Morning Report: The Fed is looking for new recessionary indicators

Vital Statistics:

Last Change
S&P futures 2790 16
Eurostoxx index 384.01 2.61
Oil (WTI) 70.92 0.54
10 Year Government Bond Yield 2.86%
30 Year fixed rate mortgage 4.53%

Stocks are higher after China made some conciliatory comments regarding the trade situation. Bonds and MBS are flat.

Inflation at the consumer level remains under control, with the consumer price index rising 0.2% MOM / 2.9% YOY. Ex-food and energy it rose 0.2% / 2.3%. These numbers were more or less in line with Street expectations. Energy, especially petroleum drove the increase in the index. Housing also pushed up the index, while autos and utilities exerted downward pressure.

Initial Jobless Claims fell to 214,000 last week, which is at levels we haven’t seen since the early 1970s (when we had a draft).

Loan performance continues to improve, according to CoreLogic. The 30+ DQ rate fell from 4.8% to 4.2% in April. DQ rates are near historic lows, except for FL, TX, and LA which are still dealing with the fallout from Hurricane Harvey. The national foreclosure rate fell by 10 basis points to 0.6%. Home price appreciation of 7% is helping matters. In fact, home equity is increasing rapidly, but HELOC are not.

As the 2s-10s spread decreases, many in the financial press are worrying whether the slope of the yield curve is signalling a recession. We already have some strategists calling for the yield curve to invert sometime in 2019. An inverted yield curve (where short term rates are higher than long term rates) has historically been a strong recessionary signal. As a general rule, the yield curve flattens during tightening cycles. In fact, it did invert in the late 90s (before the stock market bubble burst) and during the real estate bubble (before the Great Recession).

tightening cycles

Recent Fed research indicates the 2s-10s spread may not be the best signal of an upcoming recession. It suggests the spread between the 3 month T bills and 18 month Treasuries could be more predictive. Another signal is the Eurodollar futures market. The idea is that the Fed would use these indicators as a yellow signal and stop tightening before they risk a recession.

To me at least, the last two recessions had very little to do with the Fed. We had a stock market bubble, and we had a residential real estate bubble. To say the Fed caused those recessions implies that these bubbles would have kept on going had the Fed just stayed away (or stopped tightening sooner). That is a big assumption – all bubbles eventually come to an end, and when they do you have a recession. The tightening may have been the catalyst to initiate the recession, that is a question of “when,” not “if.” We were going to have a recession given we had a bubble in place already. And the Fed might have been guilty of causing the bubble in the first place, but that is a separate question.

Of course, all bets are off when it comes to this yield curve versus the past. The size of the Fed’s balance sheet relative to the economy is vastly different this time around. Pre-Great Recession, the Fed had about $800 billion worth of assets. Now it is about $4.4 trillion. To draw comparisons, you would have to estimate where the 10 year would have been without Operation Twist, QE1, QE2, and QE3. Punch line, the yield curve may in fact invert if the Fed continues to tighten and inflation remains under control. The signal-to-noise ratio of the yield curve is extremely low, so take it with a grain of salt.

Author: Brent Nyitray

Why do you need new bands? Everyone knows rock attained perfection in 1974. It's a scientific fact. - Homer Simpson

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