Debt Ceilings, Tightening Credit and Inverted Yield Curves - An Impending Recession?
With almost all macro indicators flashing red, it seems a recession is on the brink. As the world's largest economy, the United States economic climate largely underpins the future of the global economy. As such, T. Rowe Price’s Sebastian Page, and his support for the US bear case through his ‘four horsemen’ of recession: an inverted yield curve, falling PMI’s, tightening credit conditions and rising unemployment, provides cause for concern in Australia.
Horseman 1 - Yield Curve Inversion
Yield curve inversion (Figure 1) occurs when short term bonds offer higher yields than longer term bonds for the same securities. This indicates expectations for future interest rates to be lower, commonly associated with recession.
Horseman 2 - Falling PMI’s
PMI’s (or Purchasing Managers Index) are monthly surveys conducted by supply chain managers across 19 US industries to indicate the prevailing direction of the economy. The benefit of PMI analysis is its leading nature, with trends that ‘precede changes in the trend in major estimates of economic activity and output’. With 5 Sub-50 PMI results (Figure 2) in row, representing a contraction, April 2023’s 50.2 narrowly missed continuing the trend.
Horseman 3 - Tightening Credit Conditions
Tightening credit conditions occur when the availability of loans decline and procedural requirements increase. As default risk rises, banks become more hesitant to lend money, leading to ‘weak business investment and hiring’ for firms. A FED survey in early May emphasised these conditions, where ‘46% of loan officers reported a tightening of lending standards’.
Horseman 4 - Rising Unemployment
Unemployment rises as firms make employees redundant, holding a slew of negative consequences discussed in prior ASJ articles. This increase is commonly associated with recession, as firms aim to minimise the approximate 70% of expenses employees make up. While current unemployment data does not reflect this trend, its nature as a lagging indicator does not undermine the bear case.
An Added Catalyst - The Debt Ceiling
A final factor that may catalyse the bear case is the current US debt ceiling crisis. Differing from other nations, the US has run a budget deficit that averages nearly $1 trillion USD for the last 22 years (Figure 3). To make up this difference between receipts and revenues, the US must continue to borrow money, but at the same time not exceed the debt ceiling.
Sitting at around $31.4 trillion, in January the US breached this number (Figure 4), meaning they were unable to continue borrowing. Once they hit this limit, ‘X-date’ fears once again rose from their 2011 debt crisis shadows, wherein the US would default on their debt repayments.
US Treasury secretary Janet Yellen predicted this X-date arrival to be as early as ‘June 1st’, urging congress to raise the ceiling. If this date came about with no change, the US defaulting on their loans would ‘rock financial markets and throw the global economy into a financial crisis’ (New York Times).
However, at the moment, top US Congressional Republican Kevin Mcarthy and President Joe Biden are ‘coming together because there’s no alternative’, with Biden cancelling an Australian visit to avoid default. While it remains uncertain what exact direction congress will take, markets have shown optimism with 1-Year US Credit Default Swap (CDS) spreads declining.
Acting as an insurance product against exposure to treasury bonds, this decline draws parallels to the 2011 US Debt crisis, where CDS spreads were at all time highs and then sharply declined after recovery efforts (Figure 5). In 2011, Republicans agreed to raise the debt ceiling in exchange for sharp spending cuts, and it seems the market feels the same will happen now.
Criticisms of this debt ceiling have sparked as of late, because the congress legislated ceiling only serves as a cap for borrowing they have already authorised. This places strain on legislators and markets as the economy waits for an inevitable rise in the debt ceiling.
A Sliver of Hope - GDP Growth
However, one of the few economic indicators that doesn’t support this bear case is ironically the definition of recessions- 2 consecutive quarters of falling GDP growth. While 2022 Q1 and 2022 Q2 fit this definition, 3 consecutive quarters of positive GDP growth undermines a bearish outlook.
Ultimately, with recession at a 5.93% chance for June and 17.63% for July (Figure 6), it is probably best to start buckling down and picking up some extra shifts while you have the chance, as it feels an impending recession is on the horizon.
With almost all macro indicators flashing red, it seems a recession is on the brink. As the world's largest economy, the United States economic climate largely underpins the future of the global economy. As such, T. Rowe Price’s Sebastian Page, and his support for the US bear case through his ‘four horsemen’ of recession: an inverted yield curve, falling PMI’s, tightening credit conditions and rising unemployment, provides cause for concern in Australia.
Horseman 1 - Yield Curve Inversion
Yield curve inversion (Figure 1) occurs when short term bonds offer higher yields than longer term bonds for the same securities. This indicates expectations for future interest rates to be lower, commonly associated with recession.
Horseman 2 - Falling PMI’s
PMI’s (or Purchasing Managers Index) are monthly surveys conducted by supply chain managers across 19 US industries to indicate the prevailing direction of the economy. The benefit of PMI analysis is its leading nature, with trends that ‘precede changes in the trend in major estimates of economic activity and output’. With 5 Sub-50 PMI results (Figure 2) in row, representing a contraction, April 2023’s 50.2 narrowly missed continuing the trend.
Horseman 3 - Tightening Credit Conditions
Tightening credit conditions occur when the availability of loans decline and procedural requirements increase. As default risk rises, banks become more hesitant to lend money, leading to ‘weak business investment and hiring’ for firms. A FED survey in early May emphasised these conditions, where ‘46% of loan officers reported a tightening of lending standards’.
Horseman 4 - Rising Unemployment
Unemployment rises as firms make employees redundant, holding a slew of negative consequences discussed in prior ASJ articles. This increase is commonly associated with recession, as firms aim to minimise the approximate 70% of expenses employees make up. While current unemployment data does not reflect this trend, its nature as a lagging indicator does not undermine the bear case.
An Added Catalyst - The Debt Ceiling
A final factor that may catalyse the bear case is the current US debt ceiling crisis. Differing from other nations, the US has run a budget deficit that averages nearly $1 trillion USD for the last 22 years (Figure 3). To make up this difference between receipts and revenues, the US must continue to borrow money, but at the same time not exceed the debt ceiling.
Sitting at around $31.4 trillion, in January the US breached this number (Figure 4), meaning they were unable to continue borrowing. Once they hit this limit, ‘X-date’ fears once again rose from their 2011 debt crisis shadows, wherein the US would default on their debt repayments.
US Treasury secretary Janet Yellen predicted this X-date arrival to be as early as ‘June 1st’, urging congress to raise the ceiling. If this date came about with no change, the US defaulting on their loans would ‘rock financial markets and throw the global economy into a financial crisis’ (New York Times).
However, at the moment, top US Congressional Republican Kevin Mcarthy and President Joe Biden are ‘coming together because there’s no alternative’, with Biden cancelling an Australian visit to avoid default. While it remains uncertain what exact direction congress will take, markets have shown optimism with 1-Year US Credit Default Swap (CDS) spreads declining.
Acting as an insurance product against exposure to treasury bonds, this decline draws parallels to the 2011 US Debt crisis, where CDS spreads were at all time highs and then sharply declined after recovery efforts (Figure 5). In 2011, Republicans agreed to raise the debt ceiling in exchange for sharp spending cuts, and it seems the market feels the same will happen now.
Criticisms of this debt ceiling have sparked as of late, because the congress legislated ceiling only serves as a cap for borrowing they have already authorised. This places strain on legislators and markets as the economy waits for an inevitable rise in the debt ceiling.
A Sliver of Hope - GDP Growth
However, one of the few economic indicators that doesn’t support this bear case is ironically the definition of recessions- 2 consecutive quarters of falling GDP growth. While 2022 Q1 and 2022 Q2 fit this definition, 3 consecutive quarters of positive GDP growth undermines a bearish outlook.
Ultimately, with recession at a 5.93% chance for June and 17.63% for July (Figure 6), it is probably best to start buckling down and picking up some extra shifts while you have the chance, as it feels an impending recession is on the horizon.
