Macroeconomics: US recession risks rise

We remain cautious on America’s outlook as the Federal Reserve’s year-long campaign of interest rates hikes to curb inflation may lead to recession in the second half of 2023 to the detriment of risk assets.

Source: Bank of Singapore, Bloomberg.

Firstly, the US manufacturing ISM survey - a key indicator of confidence - has printed below 50.0 for the last four months as the chart shows. Readings above 50.0 indicate firms expect activity to expand while results below 50 imply activity is anticipated to contract.

Secondly, March’s US unemployment rose from a 53-year low of 3.4% to 3.6%. The US jobless rate remains very low. But when its level rises by 0.5% percentage points within a 12-month period, the deterioration in employment historically has been sufficient to push the US into recession each time since the Second World War.

Source: Bank of Singapore, Bloomberg.

Thirdly, the US Treasury yield curve has been inverted for nine months now as the chart above shows. Fed rate hikes have caused investors to mark down future growth prospects. Thus, short-term 2Y yields, that track the fed funds interest rate, have traded above longer-term 10Y yields, signalling the economy is at risk of contracting.

More recently, the spread between 2Y and 10Y yields - that had been as wide as 100bps - has begun to narrow. Investors, concerned about the sudden flare up in financial stability in the US and Switzerland, are anticipating the Fed will be forced to cut interest rates in the next few months as America’s economy nears recession.

Lastly, this month’s failure of a few small US banks is likely to tighten financial conditions. Depositors have been shifting funds to larger banks. Thus, smaller banks may become less willing to lend to borrowers, increasing the risk of a credit crunch.

We expect the Federal Reserve will respond to the uncertain outlook by pausing its fed funds rate hikes after one last 25bps rise to 5.00-5.25% in May. But sticky inflation may stop the Fed cutting interest rates later this year even if the US economy suffers recession.

Thus, we think investors should remain cautious on risk assets. In contrast, we continue to favour US Treasuries and high-quality corporate bonds as safe-haven hedges against the rising risks of a US recession in the second half of this year.

• We forecast the US will suffer recession in the second half of 2023 as interest rate hikes sap activity. We thus stay cautious on the outlook.
• Firstly, the US manufacturing ISM survey shows the sector has been shrinking for four months. Second, US unemployment rose in March from 3.4% to 3.6%. Third, the yield curve - a leading indicator of recession - has been inverted for nine months and, fourth, the failure of small US banks is set to tighten financial conditions.
• We expect the Federal Reserve will respond by pausing its fed funds rate hikes after one last 25bps rise to 5.00-5.25% in May. But sticky inflation may stop the Fed cutting interest rates later this year even if the US suffers recession.

We remain cautious on America’s outlook as the Federal Reserve’s year-long campaign of interest rates hikes to curb inflation may lead to recession in the second half of 2023 to the detriment of risk assets.

Source: Bank of Singapore, Bloomberg.

Firstly, the US manufacturing ISM survey - a key indicator of confidence - has printed below 50.0 for the last four months as the chart shows. Readings above 50.0 indicate firms expect activity to expand while results below 50 imply activity is anticipated to contract.

Secondly, March’s US unemployment rose from a 53-year low of 3.4% to 3.6%. The US jobless rate remains very low. But when its level rises by 0.5% percentage points within a 12-month period, the deterioration in employment historically has been sufficient to push the US into recession each time since the Second World War.

Source: Bank of Singapore, Bloomberg.

Thirdly, the US Treasury yield curve has been inverted for nine months now as the chart above shows. Fed rate hikes have caused investors to mark down future growth prospects. Thus, short-term 2Y yields, that track the fed funds interest rate, have traded above longer-term 10Y yields, signalling the economy is at risk of contracting.

More recently, the spread between 2Y and 10Y yields - that had been as wide as 100bps - has begun to narrow. Investors, concerned about the sudden flare up in financial stability in the US and Switzerland, are anticipating the Fed will be forced to cut interest rates in the next few months as America’s economy nears recession.

Lastly, this month’s failure of a few small US banks is likely to tighten financial conditions. Depositors have been shifting funds to larger banks. Thus, smaller banks may become less willing to lend to borrowers, increasing the risk of a credit crunch.

We expect the Federal Reserve will respond to the uncertain outlook by pausing its fed funds rate hikes after one last 25bps rise to 5.00-5.25% in May. But sticky inflation may stop the Fed cutting interest rates later this year even if the US economy suffers recession.

Thus, we think investors should remain cautious on risk assets. In contrast, we continue to favour US Treasuries and high-quality corporate bonds as safe-haven hedges against the rising risks of a US recession in the second half of this year.

This article was first published by Bank of Singapore on March 29, 2023. The Opinions expressed in this publication are those of the authors. They do not purport to reflect the opinions or views of Bank OCBC NISP Private Banking Tbk. or its affiliates.

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