Last week, financial markets around the world were rattled by the infamous inversion of the US Treasury yield curve. The yield on the 10-year note dipped below the yield on its two-year equivalent for the first time since 2007, a signal that has historically and reliably preceded economic recessions. Further analysis indicates a recession can occur up to two years after the inversion of the two-year and 10-year yields taking place. Normally, the yield curve—which plots the return on holding US government debt for multiple tenors—is upward sloping. In other words, investors are rewarded with a greater return for tying up their capital for longer. The curve also serves to act as an indicator of future interest rates, so an inversion would dictate that interest rates are expected to fall over time. This interest rate path typically occurs when economic growth is weak and needs stimulating—a characteristic of economic recessions.
Wednesday’s event sent equity markets across the board down by 2-3% and pushed bond yields lower as investors sought after safe-haven assets; the Japanese Yen gained 1.0% on the day. The market reaction of the inversion highlights the importance of psychological barriers, and now that the barrier of the two-year and 10-year yield curve inversion has been breached, investors will be keeping a close eye on market trends for more signals of an impending recession. Looking back, the S&P 500 gains 15% on average following a yield curve inversion before being hit by a recession-related drawdown. Delving deeper, Bank of America analysts note the S&P 500 can peak within three months of the inversion, or it can take up to two years. Examining the previous 10 inversions, the S&P 500 reached highs within three months, six times. In the other four inversions, it took between 11 and 22 months before the S&P 500 topped out. While the timing of the equities peak is difficult to predict, any sign of equity prices topping out can now be used as supporting evidence of an imminent recession, given that the yield curve has already inverted.
While the current state of financial markets suggests economic contraction may be just around the corner, the fundamental data is mixed. Outside the US, much of the data looks poor; Germany just recorded a quarter of negative growth—one more, and they’re in a technical recession—and China’s latest growth figure is the lowest in nearly three decades. What’s more, central banks around the world have just started to lower interest rates to support their deteriorating economies. While this includes the Federal Reserve, their interest rate reduction was dubbed a ‘mid-cycle adjustment’ and was more likely an insurance cut against growing downside risks from overseas. However, most would argue that the domestic US economy still looks strong underlined by impressive consumer activity, indicating that recession is still some way off. While the US economy tends to lead the global economic trend, it seems as though the latest economic slowdown is hitting the US last. Despite this, now that we’ve seen those early warning signs that recession is nearing, investors will certainly look for a deterioration in the data to confirm their view.
At the tail-end of last week, the Pound broke through 1.21 against the US Dollar having tested the level three times earlier on in the week. Sterling may find support at the 1.21 level this week as recent gloomy no-deal Brexit outcomes weigh on the Pound. With little in the way of UK data this week, politics are likely to be the main driver of the Pound.
Tuesday will bring the UK’s first notable data point with CBI Industrial Order Expectations. Although it is expected to read -25, this is up from last month’s -34. The measure has significantly worsened this year, suggesting the UK’s industrial sector is being hit hard from Brexit uncertainty.
CBI Realised Sales out on Thursday will indicate how the consumer side of the economy is holding up as the supply-side deteriorates. A decline of -13 is expected this month following July’s poor -16 reading.
Last week, the trade-weighted US Dollar Index climbed above the 200-daily moving average and ended the week 1.0% higher on mounting fears that a global recession is near.
On Wednesday evening, the latest Federal Reserve meeting minutes will be released, giving investors valuable insight into the central bank’s view of the US economy and providing clues about upcoming monetary policy decisions.
Flash Manufacturing and Services PMI’s will be released on Thursday, and both are expected to expand slightly more than last month.
On Friday afternoon, Fed Chair Jerome Powell will be speaking on day two of the Jackson Hole Symposium, where various central bankers, policymakers, academics, and economists meet for three days.
Last week the Euro wiped out most of the gains made at the beginning of the month, trading back below 1.11 against the Dollar with resistance at the figure. With concerns over a German recession building, important Purchasing Managers’ Index data out this week could anchor expectations of a looming German recession.
All content is written by the Global Reach Trading Desk. The opinions expressed are not the view of Global Reach Group and are not intended as investment advice.