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December 8, 2022

Financial tensions ease, recession signals flash, Asian reserves melt

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Julius Probst
Arnaud Lieugaut
Patrick Malm
Karl-Philip Nilsson
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US financial conditions are easing

Despite the rate increases, US financial stress is easing again.

This chart shows a financial conditions index that we constructed at Macrobond. It applies a principal component analysis to several financial time series, including the policy rate, equity prices and volatility, the exchange rate and credit conditions. 

The spike during the crisis of 2008 is obvious, as is the somewhat smaller shock during the early days of the pandemic. (The Federal Reserve’s monetary policy response was much more aggressive.) 

The tightening that occurred throughout 2022 was a result of rising interest rates and falling asset prices. But the latter effect has now somewhat reversed, easing the tension.

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Tracking the world of central banks and inverted yield curves

The following table shows different nations’ policy rates, their last interest-rate move and the number of months since the last hike or cut. (Japan is notable for not having tightened in more than a decade; this is likely to change as global inflation persists.)

We have also calculated the proportion of yield spreads that are inverted in each nation – a classic warning sign of recession. The US is currently experiencing the most inverted yield curve; all longer-term debt tracked in the chart (2-, 3-, 5-, 7- and 10-year durations) is yielding less than the 1-year government bond.

Markets are thus telling us that the Fed is likely going to cut rates. Most likely, this will coincide with an economic slowdown – or even a recession.

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A soft landing from the Fed could mean a bright outlook for equities

Historically, stocks have reacted quite differently when the Fed ends a hiking cycle.

The following chart tracks the S&P 500’s performance before and after various interest rate peaks. The average increase is more than 12% over the subsequent year. Outliers include 1973 (era of the OPEC oil shock) and 1995 (Alan Greenspan’s “irrational exuberance” comment was made the next year).

We graphed the current cycle by assuming rates peak in May, as the markets predict. And those same markets are already pricing in a pivot to rate cuts next year. That suggests equities might actually do quite well, provided the Fed actually achieves a soft landing.

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The Powell spread and yield curves

As the Fed chairman ponders how much to keep tightening, it’s worth examining his preferred recession indicator.

The following chart displays the “Powell spread” between the yield on a three-month Treasury bill and its implied yield in 18 months’ time. We have also overlaid the proportion of yield curves that aren’t inverted (along the lines of our central bank tracker, but using more durations); with more than 80% of the spreads inverted, that’s not good news. 

The Powell spread has been one of the most accurate predictors of an economic downturn. Once a substantial share of the yield curve is inverted, a recession becomes much more likely. 

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France is generating less nuclear power than usual

France is Europe’s biggest producer of nuclear energy. In theory, that made it less exposed to the energy crisis than its neighbours when Russia cut gas shipments. However, many French reactors were shut down this year amid maintenance issues. 

The following chart tracks French nuclear electricity output week-by-week in 2022, showing how it was well below the range of production from 2014 to 2021 

In recent weeks, output has picked up in time for winter as plants under repair return online.

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Reserve assets are melting in Asia

Asian countries continuously accumulated reserves before the pandemic; after the onset of Covid-19, they surged. As nations use reserves to defend their currencies against King Dollar, that trend is over now.

As our chart shows, it’s historically unusual for Asian reserves to decline so much. The Fed’s tightening cycle has led to rising interest rates around the globe, while most currencies have depreciated quite substantially against the dollar. 

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The Bank of England’s tough recession prediction

The Bank of England’s forecasts suggest the UK’s central bank might engineer a more prolonged recession than necessary. 

The following chart shows the BOE’s forecast for nominal gross domestic product: the sum of real GDP and inflation. It suggests one of the longest recessions in UK history, with the economy contracting throughout 2023 and 2024. 

The BOE sees inflation well below 2% in 2024 while real output declines, implying below 2% nominal growth. Such a low figure is associated with lower wages and falling asset prices – a tough economic prescription associated with lower wages, falling asset prices and debt deflation. 

One is reminded of Japan’s “self-induced paralysis” of the 1990s, as Ben Bernanke put it.

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Russian shipments of cheap oil to India and China are rising

As Western nations impose sanctions on Moscow and restrict oil purchases, India and China have been buying much more Russian crude.

It’s cheaper for those nations. The following charts show the change in purchases while demonstrating how the Urals oil price has been trading at a discount to the Brent crude benchmark. 

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Falling productivity is a recessionary sign

Our final recession indicator considers productivity.

The following chart uses the composite purchasing managers index (PMI) minus employment PMI as a proxy for productivity growth. We calculated it for the G3 economies, weighting the US, eurozone and Japan by their respective GDP series. 

Our constructed measure shows a quite severe slowdown in productivity recently. It tracks OECD productivity figures quite closely as well. 

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