Bond Investors Prepare For Next US Recession

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Next summer the current US economic expansion will become the longest in history, but it will still pale next to the runs of some other major countries. What nurtures long bouts of growth, and could the US enjoy a similar spell?

Concerns that the US economy could keel over either before or soon after breaking its 1990s record are plentiful. Most fund managers surveyed by Bank of America think the next recession could strike in the second half of 2019 or early 2020, and the bond market is whispering it could happen even sooner.

The Federal Reserve’s interest rate increases have dramatically flattened the yield curve — the difference between short and long-term Treasury rates. When the curve inverts as short rates rise above those at the long end, it has historically been an accurate harbinger of a coming recession.

The curve has steepened this week, driven by speculation that the Bank of Japan could tweak its ultra-accommodative monetary policy stance. But if the Fed stays its course, the US yield curve should invert this year.

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But maybe the bond market is wrong? It is always risky to say ‘this time is different’, but the yield curve has undoubtedly been distorted by the cross-currents of unorthodox global monetary policy, so its predictive powers may well be muffled.

Moreover, economic expansions don’t die of old age. Other countries have enjoyed much longer runs in the past, most notably Australia, which has now gone 26 years without a recession. The UK and Canada saw 16-year expansions leading up to the financial crisis, and Japan’s economy grew uninterrupted between 1975 and 1992. What nurtured these runs, and could the US enjoy something similar?

Goldman Sachs’s David Mericle has examined the record, and on three counts, the US scores badly.

First, so-called “automatic stabilisers” — such as robust unemployment benefits that buttress consumer spending in downturns — are weak.

Second, the US is already running a hefty budget deficit that could (for political reasons if not practical ones) limit its ability stimulate a struggling economy.

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Third, US households borrow more at fixed borrowing costs. That makes the economy less sensitive to interest rates — and monetary policy becomes harder to calibrate both in booms and busts.

On the plus side, the labour market shows few signs of nurturing a strong inflationary upswing that would compel the Fed to slam on the brakes. The banking system is also in much better shape than ahead of past downturns, and there are few signs of dangerous financial imbalances, according to Goldman Sachs.

So the odds on this economic run becoming a US record-breaker look good, but rivalling Australia’s economic marathon looks very difficult. Stabilising the labour market at a sustainable, non-inflationary rate without triggering a recession is a difficult feat, and the longer the expansion continues to improve the harder it will become for the Fed to engineer a “soft landing”.

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