Date
21 November 2018
Fed Chairman Jerome Powell is not especially concerned about empirical evidence that inversion of the yield curve has preceded each recession since World War II. Photo: Reuters
Fed Chairman Jerome Powell is not especially concerned about empirical evidence that inversion of the yield curve has preceded each recession since World War II. Photo: Reuters

Standing firm against recession

Amid optimism about the strong performance of the US economy, it is worth noting that second-quarter real GDP growth of roughly 4 percent was well above the 2.0-2.5 percent rate most private economists consider sustainable. With US population increases minimal at best, and with productivity gains hard to come by, the accelerated pace of nominal economic growth heightens the risk of more-rapid inflation in the near future.

Over the next year or so, a decade-long borrowing binge likely will continue. Governments and businesses are set to borrow record amounts in global capital markets. In the US alone, the federal government will likely borrow more than USD 1 trillion in fiscal year 2018 and businesses will need to refinance about US$4 trillion of bonds, almost all of them at higher interest rates. Some debt-laden state and local governments, as well as numerous businesses, may become unable to function. Despite this caution, a credit crisis does not yet seem imminent.

Financial markets shake off central bank policies

Actual and projected reduction in monetary accommodation by the Big Three central banks – the Federal Reserve, the European Central Bank and the Bank of Japan – likely will not be felt by financial markets until at least the middle of 2019. The Fed’s guidance has resulted in a narrow trading range, with a soft ceiling and floor, for its policy rate over the near term. And so far, balance-sheet normalization has put only mild upward pressure on money market rates, mainly from a surge in repo market financing as securities dealers expand their inventory of Treasury securities.

Reduced accommodation by major central banks likely won’t be felt by markets until at least mid-2019.

At some point, the economic outlook will change and a new trend or wider interest rate trading band will follow. Until then, longer-maturity yields likely will continue to trade in narrow bands while short-term rates continue to experience mild upward pressures from market forces and policy decisions by the Federal Reserve, leaving the yield curve relatively flat.

Don’t fear the yield curve

Fed Chairman Jerome Powell is not especially concerned about empirical evidence that inversion of the yield curve has preceded each recession since World War II. Productivity is the main driver of the neutral rate. Although productivity has edged upward lately, it still is too early to tell whether what we are seeing is a new trend. The modest increases in productivity leave the term premium as the only unquestioned driver of potentially higher long-term interest rates – and it is unlikely to rise significantly anytime soon.

So, if Mr Powell’s interpretation of the yield curve proves to be correct, inversion of the yield curve should not be troubling as long as current short-term rates remain around, or even below, their expected longer-run average values.

Although neither interest rate nor balance sheet normalization by the Fed have yet disrupted financial markets, continued draining of funding liquidity can set conditions conducive to an eventual liquidity crisis.

With increasing frequency, the prices quoted by dealers do not match those “asked” by sellers. Some investors, especially large asset managers, have been prompted to shift to other markets, potentially drying up funding liquidity in abandoned markets and exacerbating a potential liquidity disappearance.

From a hedger’s or speculator’s perspective, reductions in available trading size highlight the risk that liquidity could become scarce or even disappear – if markets sell off. Extreme volatility in February 2018 seems to support this point. Whether and how quickly debt levels turn into a problem depends on monetary policy and how the economy fares.

In a benign scenario – one in which corporate earnings rise across the board and the Fed raises rates at a slow and predictable pace – the debt ratio of companies may even fall.
However, if more worrying scenarios come to pass, such as a severe trade war or faster than expected Fed tightening, more indebted companies may find their debt burdens difficult to overcome. Investors should consider investing cautiously, with liquidity in the forefront of their allocations.

Invest in uncorrelated asset classes

If real economic growth comes under pressure as interest rates increase, premium asset prices in all asset classes likely will lose their raison d’être and eventually will fall. The potential harm to valuations that sets in will not be the result of the next recession. Instead, it probably will cause the next recession.

Dynamic adjustments in the US and global economy and financial markets in response to monetary, fiscal, regulatory and trade policy changes can be expected to prompt rotations in asset markets among and within all asset classes. Even if there were to be a rising tide, it would be unlikely to lift all boats. Such conditions call for a multi-pronged approach:

1. Extensive diversification across uncorrelated asset classes;
2. The willingness and ability to move quickly into and out of positions;
3. Placing a high priority on the most liquid-possible holdings within each asset class; and
4. A preference for active managers who can take advantage of idiosyncratic opportunities.

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RC

As Global Strategist at Allianz Global Investors, Neil Dwane is responsible for presenting strategic house views and overseeing the Economics and Strategy Research teams.

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