Are We There Yet? Recession Signals to Watch

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What You Missed: Interest rates fell across the curve, and equities were sharply higher on the week as investors shifted their focus from inflation to the risk of recession. Financial markets reduced their expectations of a long series of sequential Fed rate hikes on softening economic data and falling commodity prices. The yield on the US 10-year Treasury note declined to 3.09% from 3.26% a week ago, along with declines in the two, three and five-year Treasury yields. Elsewhere, the price of a barrel of West Texas Intermediate crude oil fell about $5 to $105.50, as the US Dollar and Gold both weakened. Treasury yield volatility, a key driver of the cost of rate caps and other option-based interest rate hedges, fell precipitously, but remains near two-year highs.

Defeasance Sets You Free. It’s time you got to know members of the Derivative Logic team. Steve Morus is Derivative Logic’s Director of Defeasance Services. He helps our clients get free of their mortgage obligations when their loans have become part of an investment security, such as a CMBS. We asked Steve if defeasances have picked-up this year.

Steve: “Yes, very much so. The community of people making it possible for borrowers to defease their loans is very small. As a Defeasance Consultant I’m in touch with all of them, and everyone is as busy as they’ve ever been. When you need to refinance or sell your property but can’t because your loan doesn’t allow you to prepay, that creates a major headache for you to deal with. Our clients depend on our defeasance expertise to guide them through an exacting legal process and appreciate how we make the experience as stress and worry-free as possible.”

Signals of a growth slowdown are growing by the day. The pace of economic growth in major economies significantly slowed in June, according to flash purchasing managers’ indices for the US and eurozone. Both slowed, with the US reading falling to a 23-month low. Although all indicators are still above 50 – the threshold that distinguishes growth from a contraction – the services readings for both continents dropped to levels not seen since the Omicron wave five months ago. The Fed seems to agree; in a document released this week, the Fed estimated that there would be a 50% chance of a recession within the next year and a 66% chance within the next two.

Our take: It seems like everyone is quietly waiting for the economy to buckle under the strain of the Fed’s aggressive interest rate hikes. Too bad for all of us since we won’t formally recognize if we’re in a recession until months after it has already begun. So how can we detect the onset of a recession? Before we get into that, there are a couple of things to consider:

  1. How quickly rates are rising. The pace the Fed has set in its tightening actions of late is unparalleled in recent history. Having already hiked 1.50% this year, and with plans for another 0.50% in July at the least, one must look back to the late 1980s to find a similar aggressive pace, and that episode ended with a US recession. This time around, the tightening actions are global. The Bank of England raised interest rates for a fifth time in a row last Thursday, with plans of hiking more soon. The Swiss National Bank recently hiked 0.50% in a surprise move. Ahead of what many believe are major rate hikes in the euro area, the European Central Bank conducted an emergency meeting last week to discuss its so-called “anti-fragmentation” strategy, which ensured government bond spreads wouldn’t balloon as a result. To pile on, the Bank of Mexico recently raised rates 0.75% to 7.75%, the largest increase since 2008. Norway’s Norges Bank hiked 0.5% to 1.25% while signaling that another hike is likely in August rather than in September, as previously expected. Not only are rates rising, but they’re also rising quickly, and nearly everywhere.
  2. Economic data are implying a slowdown. Based on information available as of June 16, the Atlanta Fed’s GDPNow model, which functions as a real time gauge of the pace of the US economy, predicts a 0.0% rate of economic growth for Q2. Additionally, the consumer, who single handedly is responsible for 70% of US economic activity, is starting to display signs of weakness. When excluding volatile spending on autos and gas, retail sales rose an uninspiring 0.1% last month, suggesting inflation is now high enough to destroy demand for some discretionary spending. Housing is slowing as a result of higher mortgage rates. All told, recent data show a weakening but not a recessionary economy – yet. When you add global monetary tightening to the mix however, the possibility for a full-scale downturn grows considerably.

Here’s what were watching – outside of the steady drip of ecomic data –  for clues on when we’ll find ourselves in recession:

  1. The spread between two- and five-year Treasury yields. The two-year reflects the markets’ expectations of near-term Fed hikes while the five-year captures what markets expect the Fed to do afterwards. If a recession forces the Fed to cut its hiking plans short, or even cut rates, this spread should be negative, just as it has been before the last three recessions. Right now, the 5-year Treasury yield, at 3.20%, is about 13 basis points higher than the 2-year Treasury yield, at 3.07%. Thus, according to the gauge, we’re not yet in recession territory.
  2. The near-term forward spread. This gauge is one of the Fed’s favorites. It measures the 3-month Treasury yield versus what the market expects the 3-month Treasury to be in 18 months. It captures market expectations for tightening such that if it becomes negative, markets believe things are so bad that the Fed will be cutting rates soon. At present, the spread is far from being negative, implying that the Fed has plenty of runway to hike rates more aggressively before worrying about sparking a recession.

While growth momentum is certainly decelerating, the economy has not ground to a halt just yet, and probably won’t until late this year or early next. In the meantime, consumers’ solid balance sheets will allow them to continue spending, keeping inflation high, and giving the Fed reason to hike 0.50% in July, with another 0.25% in September likely.

From Kevin Morse, Advisor, pictured above: “Were you or your client required to purchase an interest rate cap to hedge a variable rate loan a year or two ago, but have subsequently paid-off that loan?  If you own a rate cap which still has time remaining until maturity, but no underlying loan to match it with, give a Derivative Logic advisor a call right away.  It is highly likely that that cap has significant value in today’s market.  We can value the contract and arrange to sell it back to the cap bank for you, allowing you to pocket significant cash – in some cases much more than what you originally paid for it.” Call us today at (415) 510-2100.

What to Watch This Week: High oil prices and inflation expectations, which fueled the Fed’s recent 75-basis-point rate hike, have reversed quickly:  Crude-oil prices, which feed directly into gas prices, have plummeted to levels last seen in early-May, while inflation expectations, what really matters to the Fed, have also declined. These developments will give the Fed confidence to hike just 0.50% at its next meeting on July 27th, lower than the 0.75% hike expected by many.

Data on tap in the days ahead will help clarify our view. May personal consumption expenditures (Thursday) are projected to drop in real terms compared to the previous month., and the housing market is progressively cooling (construction spending, Fri.). Businesses are still investing handily, but are ready to curtail production in anticipation of a slowdown in demand (ISM Manufacturing, Friday). All are factors that could slow the Fed’s hiking plans in the near term and cut them short if they worsen significantly.

In the meantime, for borrowers, flexibility in interest expense is critical. Who is helping you avoid the potholes that lie ahead?

Current Select Interest Rates:

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Source: Bloomberg Professional