Many assume last December marked the start of tighter Fed policy with the first rate hike in a decade. But overall financial conditions have been tightening since the Fed began to unwind unconventional monetary policy back in 2014. We believe the removal of unconventional monetary policy (QE tapering and ending) since that time, in combination with the strong dollar, acted like a tightening cycle even though the Fed only just raised rates.
Interestingly, the yield curve, as measured by the difference between the 2-year and 10-year Treasury yields, also started to flatten at that time, which is typically a hallmark of tighter financial conditions. Currently, that spread is near 100 basis points, having just hit an eight-year low. Declines in the benchmark 10-year Treasury yield against Fed rate hikes indicate an advanced tightening cycle and slowing nominal growth. This suggests financial conditions have become much less supportive of economic growth. Keep in mind that shifts in financial conditions work with a lag, so the recent tightening will be felt mainly in the period ahead.
Late stage business cycles are also characterized by uneven shifts in economic data and trends. We know that manufacturing is suffering, inventories are too high, capital spending is scarce, trade remains depressed by constrained global demand, and corporate profits are in contraction. These drags have kept growth and inflation soggy, but not dire. Job gains, consumer spending, and housing are the bellweathers for recession, and these appear healthy even though they have cooled on the margin. Labor markets historically are the last area to weaken, as companies have over-hired, profits begin to crack, and productivity falls even further late in the cycle. Once this occurs, income and consumption growth then begin to slow. For now, these remain the biggest factors floating economic growth. Housing also remains on track with only a slight loss of momentum. Recently, the contraction in manufacturing has eased as dollar strength has abated. But the global growth outlook remains shaky, and recession risks troublesome, although other central banks are easing.
For now, we can say the U.S. economy is late cycle, with recession risks rising but not yet elevated. Higher recession risks will center on a further slowdown of economic momentum and continued tightening of financial and credit conditions. This can result from more onerous lending standards or Fed rate increases that are out of sync with underlying fundamentals. Unless those risks are reversed, the possibility of recession later this year and into 2017 will grow. The Fed is clearly intent on hiking rates this year with a myopic focus on low unemployment igniting wage inflation. Flatter yield curves and lower long-term rates will signal rate hikes are hindering growth. Pay attention to leading indicators, especially job growth and consumption. Any weakness in these metrics will signal the expansion is at extreme risk and hopefully prompt the Fed to hold. Both monetary and fiscal policy will then need to nurse this business cycle. So while there is little near-term risk of recession, that risk is likely to grow later this year and into 2017.
Marie M. Schofield CFA, is chief economist and senior portfolio manager at Columbia Threadneedle Investments.