Highlights

• Patience remains the Fed’s new watchword

• An inverted yield curve demands attention

• Pragmatism rules the day amid recession tug-of-war

Typically, the arrival of April portends the green shoots associated with longer days and sunnier skies of spring. The brackets frenzy of the March Madness ritual also helps usher in the second quarter of the year. Soon, the earnings season takes center stage and analysts and investors alike determine how they expect the rest of the year to unfold. The transition from one quarter to the next is usually fairly straightforward. This year, however, may prove exceedingly different as questions abound over the strength of the global economy, with the U.S. economy—still on solid footing—under the microscope for signs of strength or weakness.

Internet searches for “inverted yield curve” and “recession” have picked up markedly, perhaps helping to explain the unexpected drop of the Conference Board Consumer Confidence Survey at the end of March, despite February’s rebound. While the all-important consumer was more concerned about current economic conditions, including the job market in general, U.S. consumers were more confident about the future. For example, intentions improved for vehicle purchases, as well as home-buying. At the end of March, the University of Michigan’s Consumer Sentiment Index was revised higher, reflecting a more optimistic assessment for both current and future expectations.

The Conference Board’s senior director of economic indicators explained, “Confidence has been somewhat volatile over the past few months, as consumers have had to weather volatility in the financial markets, a partial government shutdown and a very weak February jobs report. Despite these dynamics, consumers remain confident that the economy will continue expanding in the near term. However, the overall trend in confidence has been softening since last summer, pointing to a moderation in economic growth.”

The “Pivot”

The Federal Reserve, in its striking monetary policy “pivot,” at last acknowledged in early January—perhaps indirectly, and perhaps too late—that the market’s message at the conclusion of 2018 was correct in projecting a softening economic landscape that was exacerbated by rate hikes along with balance sheet quantitative tightening (QT). It was becoming increasingly clear in the real economy that the consumer and businesses were suffering under tighter financial conditions brought about by four rate hikes in 2018, coupled with the “$50 billion” monthly drawing down of the Fed’s balance sheet amid a weaker global landscape.

At the December Federal Open Market Committee (FOMC) meeting, two rate hikes for 2019 were projected as Federal Reserve Chairman Jerome Powell said, “some crosscurrents have emerged.” Moreover, despite the strong economic backdrop and expectations for healthy growth, he noted that there were developments that could be signaling “some softening.” Citing moderating global growth that nonetheless was still solid, Powell acknowledged  heightened market volatility; however, the developments did not fundamentally alter the Fed’s outlook. Rather, forecasts for growth in 2019 were lowered “modestly.” Still, the Fed raised rates for a fourth time in December 2018 and Powell said that management of the Fed’s balance sheet was on “autopilot.”

After the severe market sell-off following the December FOMC meeting, Powell offered decidedly more market-friendly comments at the January 4 annual meeting of the American Economic Association when he said “muted” inflation expectations would allow the Fed to be “patient” as they watch to see how the economy evolves. Markets responded quickly and vigorously as it became abundantly clear that the Fed had changed course. The “pivot” had begun.

“Patient” became the new watchword as the Fed became incrementally more dovish during the first quarter, and “patient” was interspersed in all of the chairman’s speeches following the January 4 about- face.

Crosscurrents And Conflicting Signals

Crosscurrents and conflicting signals in global economic data releases and surveys prompted the central banks, particularly the European Central Bank (ECB) and the Fed, to assure markets that they were watching and prepared to act. Since the beginning of the year, the Fed funds futures market has predicted zero rate hikes for 2019 and an increasing chance for a rate cut. Going into the second quarter, Fed funds futures see an above-60 percent chance of a rate cut in 2019. Testifying in February before the Senate Banking Committee, Powell said while current economic conditions remain healthy and the economic outlook remains favorable, there have been more signs of “crosscurrents and conflicting signals.” The uncertainty, he explained, was focused on Brexit, ongoing trade negotiations and several “unresolved government policy issues.”

By the March FOMC meeting, the Fed became increasingly more dovish as Powell explained the committee’s decision to remain “patient.” In what would be interpreted as mounting concern by the Fed, it was signaled that there would be no rate hikes in 2019. Importantly, the unwinding of the balance sheet, increasingly seen as a form of additional financial tightening, would be completed in September. “It is a great time to be patient,” declared Chairman Powell. Indeed.

In a recent “60 Minutes” appearance, Powell underscored the message that the Fed is not in a “hurry to change” its rate policy and would monitor the economy to see how it evolves.

Yield Watch Intensifies

Following the FOMC meeting at the end of March, during which the Fed dampened expectations for the economy, Treasury yields fell as investors factored in weakening euro- zone economic data, particularly coming from Germany, the largest eurozone economy, along with weaker- than-expected Chinese data and the prospect of the U.S. economy slowing more than previously expected. On March 22, the yield on the benchmark 10-year Treasury note declined, while the 3-month Treasury bill rate inched higher than the 10-year note, representing an inverted yield curve for the first time since 2007.

The significance of an inverted yield curve cannot be overstated. An inverted yield curve, whether it’s the 10-year Treasury note in relation to the 3-month Treasury bill, or the more commonly referred to 10-year Treasury note in relation to the 2-year Treasury note, reflects investor concerns that longer-term growth is slowing and perhaps evolving towards a recession.

During the past 60 years, according to Evercore ISI research, there has been yield curve inversion before every recession, although there have been three false signals over the same period. Data from Reuters indicate that over the last 50 years, here has only been one false signal from an inverted yield curve. And in August 2018, the Federal Reserve Bank of San Francisco, known for its research on the yield curve, published a paper discussing the 10-year to 3-month yield spread as the most reliable predictor of a recession.

There are questions as to whether it could be different this time. Did the Fed’s “experiment” in deliberately distorting the yield curve by pushing rates down to near zero affect the reliability of the yield curve’s message? Have inflows into the U.S. Treasury market from global central banks (where rates are especially low and/or negative), pension funds (taking advantage of strong equity markets and re-balancing portfolios to capture higher yields), and insurance companies—all helping to push down 10-year rates—also affected the accuracy of the yield curve in terms of projecting recessions?

The Federal Reserve Bank of Richmond, in a research paper published in December 2018, acknowledged that while yield curve inversions have preceded each of the past seven recessions, other circumstances can affect the shape of the curve besides concerns over the state of economic growth. The paper cites the minutes from the September 2018 FOMC meeting, which noted that an inverted yield curve could indicate rising chances for a recession, or central bank asset purchases that could “temper the reliability of the slope of the yield curve as an indicator of future economic activity.”

Former Federal Reserve Chair Janet Yellen weighed in on the inversion message, saying the inversion may be signaling the need for a rate cut at some point, rather than signaling a recession.

Other important indicators, including the health of credit markets where corporate bond spreads have tightened, and high yield credit spreads remain low, are important in how markets judge whether the inverted yield curve will be seen as a false signal. To be sure, each data release, indicating strength or weakness of the economy, will affect the yield curve, but for reliability, markets need to see persistence in the curve’s message, spanning weeks, not intermittent moves.

Market commentary is divided on the curve’s message, but if lower interest rates do spur auto sales and help the housing market, as recent mortgage applications indicate, the yield curve should begin steepening, indicating investor confidence in the economy. Similarly, if global growth begins to show signs of stabilization, it will also offer help in steepening the curve. All central banks, all markets, and all investors and traders are data dependent, but the yield curve, which is now being analyzed from every perspective, will remain hyper-alert for changes in economic direction. Don’t dismiss the inversion: Keep it in context with other key metrics, including PMI (Purchasing Managers Index), CDSs (credit default swaps) for high yield bonds, CRB Rind (raw industrials index), inflation expectations and unemployment claims.

Global Backdrop

As the economic slowdown unfolded in China and Europe, it seemed the U.S. would be immune to the forces causing a weaker economic landscape. And for the most part the U.S. has been resilient, but signs of U.S. domestic weakness have forced the Fed to engineer a prolonged “pause” in its monetary trajectory. Concerns are rising that the Fed was too late, and that 2018 rate hikes continue to work their way into the real economy, stifling growth. In addition, ongoing trade negotiations with China have, to some degree, slowed corporate capital expenditures as firms wait for clarity. Exports have slowed as economies in China and Europe have slowed, although U.S. exports are beginning to show signs of improvement, which should help bolster first-quarter GDP results.

The ECB has responded to slower growth in the eurozone by commenting on downside risks and curtailing its guidance for rate normalization beginning in September. In addition, the ECB has signaled its willingness to support increased “targeted longer-term refinancing operations” (TLTROs), designed to have banks lending directly into the real economy, particularly companies. ECB President Mario Draghi and ECB Chief Economist Peter Praet have suggested that if the eurozone economy deteriorates further, there remains a full range of measures that can be employed. While not discussed publicly, the ECB could resort to private asset Quantitative Easing (QE) if the economy doesn’t gain traction. Draghi discussed the slowdown in fairly generic terms by stressing that if economic growth momentum weakens further it could lead to a more broad-based slowdown, especially if external demand remains weak, and if this spills over to domestic demand.

The Bank of Japan (BoJ) continues its zero-interest rate policy and QE, along with the purchase of ETFs as part of its stimulus package.

Given China’s important role within global trade, signs of economic stabilization should help foster optimism that demand will increase for imports and exports. The most recent data include industrial profits falling sharply in January and February. Consumer confidence slowed for the fourth time in five months. As a result, China continues to lower the reserve requirement ratio for banks and is directing funding into banks to be used for loans for companies. Most likely, if necessary, officials could cut lending rates in the near term. In addition, billions of dollars are planned for tax cuts designed to help the manufacturing, transport and construction sectors. Infrastructure spending is also being given a boost. In a recent speech, Premier Li Keqiang warned that the “environment facing China’s development this year is more complicated and more severe.” He stressed that the country must be prepared for risks and challenges that are either “predictable or unpredictable.” Negotiations continue for a viable resolution to the tariff dispute, with difficulties focused on reaching an agreement on the enforcement of technology transfer, cybersecurity and intellectual property.

Earnings, The Market’s Next Test

The earnings season will allow investors to focus on top-line revenue growth to assess overall demand for goods and services. Corporate guidance will help draw a picture of the economic backdrop, something that could corroborate the bond market’s view of the economy, or change its direction if guidance surprises to the upside. The first-quarter earnings season has companies cutting revenue guidance on a daily basis. The revenue picture, coupled with corporate guidance, will become increasingly important as we go through the year if global economic conditions continue to weaken.

With the Federal Reserve on an extended “pause,” markets have responded well, but sectors leading the market higher towards the end of the first quarter have come from both defensive sectors in addition to cyclical sectors, especially technology. It’s a market that has hedged itself as worries persist over the strength of the underlying global economy. Moreover, hovering over the market is the perception that the Fed may not have acted quickly enough, and a continued deterioration in growth leaves the Fed with very little in the way of ammunition in its toolbox.

The recession “tug-of-war” in the market won’t abate until there’s clarity in the data. A spate of unequivocally stronger data releases will challenge the bears, while the bulls will declare victory. Being pragmatic and careful while the market divines its next direction is prudent. The $4.5 trillion experiment that began 10 years ago is still not over. The easy part for the market was getting to $4.5 trillion, the hard part is getting back to what normal is supposed to be. But we will get there, crosscurrents notwithstanding.

Quincy Krosby is chief market strategist at Prudential Financial.