The recent 50 basis point cut to the fed funds rate has spurred on discussions regarding the health of the US economy. While many economic indicators have softened in recent months and some — such as the slope of the US yield curve, Sahm Rule or ISM manufacturing survey — point to a recession, there are valid reasons as to why this will, which is Fathom’s central view, be avoided.
A yield curve inversion has often been touted as a sure-fire signal of a looming recession. Indeed, the yield on two-year treasuries exceeded the yield on ten-year treasuries ahead of five of the last six US recessions. However, yield curve inversions do not cause recessions. Instead, they reflect investors’ perception of monetary policy, which itself reflects the outlook for the economy. Many investors and commentators have been calling for a US recession for some time now, while the economy has continued to fare better-than-expected. As the chart below shows, the yield curve has been inverted since July 2022, with no recession forthcoming.
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The ‘Sahm rule’ is triggered when the three-month moving average of the unemployment rate increases by half a percentage point or more, relative to its low in the previous 12 months. In the US, this trigger has previously always indicated the start of a recessionary period. Indeed, this trigger has been hit recently in the US, meaning that either the rule will be wrong in the US for the first time or the US is already in recession. Meanwhile, the ISM manufacturing survey points to an economic contraction in the manufacturing sector, with the Manufacturing Purchasing Managers Index (PMI) trending downwards, below 50.
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These indicators point to weakness in the US economy, however a little perspective is required. First, while the unemployment rate has risen, triggering the Sahm rule, this has been associated with an increase in labour force participation, rather than increased layoffs. Also, it is worth noting that the Sahm rule does not work as well for countries other than the US. Second, although jobs growth has slowed significantly this year, the six-month average increase in nonfarm payrolls was 164,000 in August, similar to the average levels seen in the previous decade. Third, although the ISM manufacturing survey points to a contraction in that sector, the non-manufacturing survey, which reflects a far larger share of the economy, points towards expansion.
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This prolonged period of elevated interest rates certainly seems to have done its job of cooling the US economy, with a range of other economic indicators softening over the past twelve months. Equally, some parts of the economy, including the consumer sector and even the housing market, have shown impressive resilience in the face of higher rates. With inflation now close to target, the Fed has some scope to reduce rates further, which should ease the interest rate burden on households and corporates.
The lack of an obvious aggregate demand shock is a key reason that Fathom’s central case remains that the US economy will not experience a recession in this or the coming year. Consumer confidence has been stable and has not fallen as rapidly as has commonly been seen before the start of a recessionary period. Meanwhile, consumption is also relatively strong and has been growing faster than its pre-pandemic range. Ongoing positive real wage growth should continue to support demand. Meanwhile, the corporate sector, which is where we identified elevated recessionary risks, will benefit from anticipated rate cuts via lower borrowing costs. A recession certainly cannot be ruled out, but things may not be quite as bad as ardent followers of the yield curve or Sahm rule might suggest.
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The views expressed in this article are the views of the author, not necessarily those of LSEG.
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