HIGHLIGHTS OF THE WEEK
- There was no summer vacation from financial market volatility this week as investors were increasingly worried that the global economy is about to slip into recession.
- The difference between the 10 and 2-Year Treasury yields turned briefly negative this week, sending a signal that bond investors expect the economy to get worse before it gets better. While the risks of a recession have risen, we are not there yet.
- The U.S. data was mixed this week, with evidence that tariffs are impacting prices and the factory sector. Consumers continue to be the bright spot, and there were signs that housing may be firming too.
Markets on Edge as Recession Risks Rise
There was no summer vacation from financial market volatility this week as investors worried that the global economy is about to slip into recession. An inverted yield curve, as measured by the difference between longer and shorter-term bond yields, is one of the more reliable recession predictors. The difference between the 10-Year Treasury and the 3-Month T-bill has been negative for a couple of months now, but the difference with the 2-Year Treasury turned negative briefly this week (Chart 1).
Notably, there is a long and variable lead time on the signal coming from the yield curve. Anywhere from one to two years in the case of the 1990, 2001 and 2008 experiences. The yield curve signals that bond investors expect the economy to get worse before it gets better, but it is not a definitive signal that a recession is imminent. As we discussed late last year (see Perspective) we look at a suite of indicators to see whether we are close to a recession. Our TD Leading Economic Index has deteriorated, but is not yet flashing recession (Chart 2). It is similar to the 2015-16 slowdown, when the Fed paused on its new tightening cycle due to global weakness.
All told, the risks of a recession have increased since the White House ratcheted up trade tensions with China. That said, we still expect the Fed to continue its risk management approach and cut rates another 25 basis points in September. The negative yield curve raises the probability that they take further action in the months ahead.
The Fed is right to be wary of the risks from trade tensions, as evidence that tariffs are hitting the U.S. economy continued to mount this week. The July CPI indicated that tariffs on Chinese imports are likely lifting prices at the consumer level (likely in the neighborhood of 0.2 to 0.4 percentage points). Core goods prices have picked up in recent months. The Fed will look through one-time price increases due to tariffs, since they are a tax which ultimately crimps growth.
The manufacturing sector also continued to struggle in July. Factory production fell 0.4% in July and has been trending lower in 2019. Weaker foreign demand and elevated trade uncertainty is taking a toll on the sector (see report). Housing starts weren’t looking too hot either in July, although an increase in single-family starts, and in building permits were silver linings. This is in line with homebuilder confidence, which continued to improve in August after weakening at the end of 2018.
The bright light in an otherwise crummy week was the consumer. Retail sales were up more than expected in July, setting up consumer spending to be an impressive 3% in the third quarter, stronger than we had expected. If the global backdrop weakens more sharply than we expect, the consumer at least seems to be in a decent position to weather it.
Leslie Preston, Senior Economist | 416-983-7053
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