INSUBCONTINENT EXCLUSIVE:
The sudden inversion of the US yield curve (10Y-3Mo) on Friday to -3 bp, following the sustained decline in euro area manufacturing sector
20-times trailing earnings, one-year break-even inflation rising to a 10-year high of 3.5 per cent (up from -3 per cent in Dec, nominal bond
yield-inflation linked yield; source Bloomberg), and global crude prices rising 35 per cent from the lows of December 2018.
So, does the
foreseeable future incomes
Hence, if people are bullish about their future income, they will tend to spend more, possibly also by borrowing, i.e., saving less.
Hence,
if collectively households desire to consume more and save less, there should be an upward pressure on real interest rates, implying a
steepening of the yield curve
Conversely, if households are pessimistic about their future, the curve should flatten or get inverted
But flattening or inversion only tells us about a growth deceleration
What could make it turn into a recession are unexpected shocks.
Historical evidence shows curve flattening implies slower growth, but
recessions are triggered by shocks.
The past four recessions were indeed preceded by flattening or inversion of the yield curve, which
indicated a slowdown in consumption growth (1978-80, 1991-92, 1999-2000, 2007-08)
However, flattening or inversion of the curve also occurred without leading into a recession in 1985-86, 1994-95, 1997-98 and 2005-06.
Thus,
there are enough instances in the past where the curve flattening has not resulted in a recession
This implies that the curve inversion is not a good predictor of recession, although it makes the economy susceptible to one if there are
external shocks.
For instance, the year 1981-82 had the Iranian Revolution in the backdrop, leading to an energy crisis (1979); the 1990
recession was triggered by the Iraq War which led to a spike in oil prices; the one in 2001 was due to the dotcom bust (asset price
deflation); and the Great Depression (2007-09) also resulted from asset price bust (sub-prime crisis, stock market), impacting financial
institutions.
So where is US economy now It is in a good shape despite global headwinds.
The US economy is on a strong footing: job market
conditions remain above normal, wage growth is good, and consumer confidence indicators are strong
Tax cuts and fiscal spending created positive demand conditions last year
Though it also implies slower growth in 2019, higher investments and labour force participation are expected to create a positive
supply-side impact this year.
Financial market conditions are stable, banks are well capitalised, US households enjoy the highest-ever net
worth/personal income of approximately 7 times, and households are not much leveraged
(labour, profits, and interest payment)/GDP at 58 per cent is still fairly low, despite 10 years of economic expansion
Overall, there is no evidence of the typical cyclical excesses.
There have been some near-term concerns emanating from the volatility in
Business sentiment was impacted by tight financial conditions in Q418
This, along with trade conflicts, have impacted investment intent
So, economic activity has slowed from its solid rate in the fourth quarter.
The downgrade in US GDP growth to 2.1 per cent for 2019E from
2.4 per cent earlier is a reflection of both global headwinds and uncertainties that have evolved recently
But even at this level, it is above potential growth of 2 per cent
The core inflation projection remains unchanged at 2 per cent, although the temporary decline in crude prices may keep headline inflation
In my base case, if the US-China trade conflict gets resolved, the narrative on US economic data can change to the positive side
This will have implications for a stronger USD and rates outlook
The unknown factor is the time it will take for the resolution to emerge.
