Last week the policy-sensitive U.S. 10-year—three-month Treasury spread inverted, meaning yields on the short-term three-month Treasury bill were higher than yields on the 10-year Treasury note (Figure 1). The brief inversion implied that investors were willing to pay more for three-month short-term Treasury bills against the risk of holding depreciating long-term securities. The inversion also reflected investor expectations for a slower period of growth ahead and the increasing probability that the U.S. Federal Reserve may cut rates during the next year in response to deteriorating economy.
The proximate cause of those expectations are linked to reduced global growth concerns caused by trade tensions and the sharp U-turn in Federal Reserve policy, which effectively ended the central bank’s move toward policy normalization less than 90 days after lifting its policy rate and forecasting an additional two rate hikes this year.
The inversion of the 10-year-three month portion of the U.S. yield curve was likely linked to a spate of weak global industrial manufacturing data, most notably the IHS German Markit Purchasing Managers Index, which contracted for the third consecutive month. This weaker-than-expected sentiment indicator of German manufacturing caused the German Bund 10-year yield to slip below zero to minus 15 basis points. In turn, that triggered a global safe-haven move into U.S. short-term paper thus sending the yield curve briefly below zero. That has since triggered a “risk off” move in global financial markets that has spilled over into Asian and European markets prior to the open in New York today.
While we are now officially on recession watch, we are not yet convinced the U.S. economy will slip into a recession this year. Historically, an inverted yield curve has been a fairly reliable indicator of recession going back to the 1960s. If sustained, the inversion typically indicates that a recession will happen sometimes in the next 12 months.
That said, our view is that unless there is a more noticeable deterioration in the global economic picture and some additional incoming data showing no rebound in second half growth in the U.S., we think that this inversion will likely end up being be a near miss.
Our preferred metric of financial conditions (Figure 2) remains 1.73 standard deviations above neutral, indicating financial conditions remain broadly supportive of growth though at a slower pace than 2018. This suggests there has been an overreaction in financial markets to the slowing U.S. and global economies.
For now we still expect a soft first quarter growth rate of 0.4 percent, followed by a mild rebound to 1.5 percent in the second quarter before the economy returns to its long-term trend growth rate of 1.8 percent in the second half of the year. The risks to the economic outlook continue to revolve around the series of trade conflicts the U.S. is ensnared in and the likely lower trajectory of global growth linked to those conflicts, which are the primary cause of the financial volatility across global markets since October 2018.
Forward-looking policymakers and investors should anticipate a rough patch in financial markets during the next several weeks as corporate earnings for the first quarter arrive. With the consensus expecting a mild decline in corporate earnings, along with recent sluggish global economic data, conditions are ripe for further financial market volatility.