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The continued effects of US yields can be felt across the entire asset class today. Following Friday, we are seeing risk sell-off in FX, equity indices and bond yields. The FX risk basket of TRY, BRL and ZAR have been hammered with the JPY as the primary destination for safe-haven flows. The yield on the 3 Month Treasury Bill rose above the yield for 10-year Treasuries for the first time since 2007, generating forewarnings that the US is headed for recession in early 2020. The move was generated by FOMC dots indicating solid expectations for a pause in 2019 and raising the probability that the next move will be an interest rate cut.
Historically, yield-curve inversions precede significant economic slowdowns by about a year. While some high-status pundits have suggested that it's different this time, the actions have already triggered a self-fulling prophecy. The San Francisco Fed's Michael Bauer and Thomas Mertens wrote last year that the "the traditional 10 yr-3-month spread is the most reliable predictor (of recession)". Note: The US 10-year, 3-month curve inverted ahead of the 1990-91, 2001 and 2007-09 recessions.
On the policy side, we believe that the Fed will pause its currency hiking cycle indefinitely. Core PCE (Personal Consumption Expenditure) inflation has been running below 2% y/y so there is little need for the FOMC to be aggressive. In addition, the growth slowdown indicates that any overshoot would hit meaningful headwinds. The theory of no further hikes this cycle is also supported by the fact that unconventional policy in balance sheet reduction has also turned dovish. Yet the Fed's concern is less about growth outlook, which has remained solid but at risk to financial conditions. Instead, it seems to have become hypersensitive to risk in the financial markets. This outlook should be USD negative, however, as there is increasing worry that Europe and the ECB are not behind the curve. We don't expect the ECB to cut rates any time soon but the outlook for tighter Euro-area monetary policy is now fading. Our US-EU convergence theory that would have given the Euro a boost need to be side-lined.
The US economy is decelerating as the boost stimulated by tax cuts begins to dwindle and the trade war with China begins to bite. Other factors such as political discourse, partial government shutdown and poor Fed communications are hard to measure, but they clearly cast a combined shadow on the economic outlook. In theory, investors now expect that short-term rates will fall as the Fed's next move will be to cut interest rates. The rational for the Fed to cut is that the economy is slowing sharply, and recession warning lights are blinking.
Those who argue that the US will avoid a sharp economic fall point to the strong labor market and positive consumption data. With over 70% of GDP derived from this critical sector, jobs underpin American consumption. An extraordinarily strong hiring cycle has attracted new workers into the labor force, which has increased incomes and expanded the consumption base. If you also factor in the positive trend in wage growth, you have a compelling story for a soft economic slowdown that will avoid recession. However, the problem with having an ultra-strong labor market that has seen monthly job gains of over 200K is that it would not take much for companies to begin slashing payrolls due to perceived negative signals. The US employee psyche has been scarred by the extended hardship of the financial crisis, and if media and data light up to HR cuts, US consumer would quickly move into a defensive position — lower spending. It is critical to mention that left-leaning US media would then be happy to headline this as President Trump's economic failure, even if it meant their own downfall.