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In Search of a Downturn

Swings in economic activity over the past two years have been unusually large with most advanced economies experiencing deep recession in mid-2020 and strong growth, albeit bumpy at times, since. The global pandemic and restrictions to contain it were responsible for the deep recession and the bumpiness of the recovery since. The power behind the post-recession recovery came from a large-scale lift in government spending combined with central banks ramping up their balance sheets with bond purchases and keeping interest rates exceptionally low.

Easy policy conditions excited a strong rise in business and household spending which in turn is driving up business investment spending and employment and driving down unemployment rates to multi-decade lows. In Australia, the March labour force report out this week may show that the unemployment rate has fallen below 4% for the first time in more than 40 years.

Unusually strong economic growth – Australia's most recent Q4 2021 GDP reading was up 3.4% q-o-q, the strongest quarterly growth reading in more than 30 years – is placing upward pressure on inflation. A change in consumer spending pattern during the pandemic in favour of goods rather than services coincided with global shortages of many manufactured goods caused by supply disruptions made worse by pandemic restrictions has added to inflation pressure. The long period of disinflation since the late 1980s seems to have ended.

Changing inflation prospects have caused financial markets to recalibrate their views about the economic outlook. In the US, where inflation is high and seemingly entrenched (the March CPI out this Tuesday may see annual inflation lift to 8.5% y-o-y from 7.9% in February) financial markets are factoring in a more aggressive policy tightening pattern by the Federal Reserve, at least 25bps rate hikes every six-weekly policy meeting for the remainder of 2022 and during 2023 combined with the Fed starting to sell down its bond holdings.

The minutes of the March Fed policy meeting plus recent speeches by senior Fed officials back up the views in the market that the Fed will tighten more aggressively although are at odds with what the Fed has done so far, cautiously delivering at its March meeting a 25bps rate hike taking the Fed Funds rate to 0.25% to 0.50% range. Despite what in practice so far seems to be a “talk tough, act soft” approach by the Fed, the US bond market has taken to heart the prospect of aggressive Fed policy tightening pushing up all US bond yields and particularly shorter-term bond yields taking them above longer-term bond yields.

The inverted US bond yield curve is a signal that the bond market is factoring in a turn in US economic fortunes from strong economic growth to recession within the next year or two. While it is possible that over-aggressive Fed policy tightening could tip the US economy into recession next year, the bond market call looks premature to us.

There is no sign in what the Fed has done so far or in the interest rate forecasts of the Fed governors and presidents that the Fed will deliver over-aggressive policy tightening. The Fed governors are indicating a Funds rate around 3% over the next two years to combat an annual inflation rate peaking above 8% y-o-y in the near term and cycling down on base effect to 4% or so next year. The Fed stays well behind the curve fighting inflation on these forecasts.

Moreover, there is considerable growth momentum in the US economy from further government spending and strong household income growth that is likely to stay supported for several more months at least by very tight labour market conditions generating low unemployment and further increases in wages. Strong US growth seems baked in for at least the remainder of 2022.

In Australia, the bond yield curve has not inverted yet and neither should it on local growth prospects that look very firm in the near term. The pre-election Budget delivers more income support for households in the near term. Employment growth is very strong as will be seen in the March labour force reading this week. National income is being boosted by the big lift in export commodity prices so far this year.

Despite strong growth prospects the lift in inflation in Australia although significant is less pronounced than in other major economies. The near-term peak in Australian inflation around 4.5% y-o-y will be around half the inflation peak in the United States. Wages in Australia are rising, but comparatively slowly. An anomaly is that the local financial market is pricing more tightening by the RBA over the next 18 months or so than US financial markets are expecting by the Fed.

We see the RBA hiking its cash rate slower and less than the Fed hikes its Funds rate through to the end of 2023. Realistically, neither the Fed or the RBA look like tightening to the point of tipping either the US or Australian economies into recession by the end of 2023. Instead, relatively strong economic growth may persist through much of the period. Those searching for an economic downturn in either the US or Australia may need to extend their search into 2024 or beyond.