Brief Macro: US 5Y-1Y Yield Curve Inverts, but 10Y-2Y Suggests US Will Narrowly Avert 2020 Recession and more

In this briefing:

1. US 5Y-1Y Yield Curve Inverts, but 10Y-2Y Suggests US Will Narrowly Avert 2020 Recession
2. Global Capital Flows Show China’s Collapsing Export Markets Could Soon Revive
3. Understanding the Widening of the U.S. Trade Deficit
4. Weak February Payrolls But U.S. Labor Market Is Still Tightening
5. Philippines: February Inflation Eases Back to BSP’s Inflation Target Range

1. US 5Y-1Y Yield Curve Inverts, but 10Y-2Y Suggests US Will Narrowly Avert 2020 Recession

The 5Y-1Y section of the US yield curve inverted sharply last week (aided by Friday’s weak NFP release), with the 5-year yield 11bp below the 1-year yield of 2.53%. (That yield spread was +1bp a week earlier). An inverted yield curve is a precursor of a recession 12-18 months later, so the probability of a US recession by 3Q 2020 is rising. However, the key predictor of a US recession is not the 5Y-1Y spread, but the 10Y-2Y spread — which remained rock-solid at 17bp last week (having fallen to that level on Monday 4th March from 23bp on Friday 1st March). The key predictor of US recessions has not yet inverted, so the most likely outcome still is that the US economy will weaken, but narrowly avert recession in 2020. 

The weak non-farm payrolls (NFP) report for February 2019 was largely in line with that outcome. Although February’s NFP increase of 20,000 was far below target, January was revised up to 311000, and the 3-month moving average of 186,000 is healthy for this late stage of the recovery. The US labour market remains tight, with the unemployment rate at 3.8% (and the broadest measure of unemployment falling to 7.3% from 8.1% in January). So wages rose 3.4% YoY in February 2019, the fastest during this 10-year recovery. Although the core PCE inflation rate is still tame at 1.9% YoY, wages are likely to exert mild upward pressure on core PCE inflation in the months ahead. But there will be little need for the Fed to raise rates in the next half year. 

The key cyclical component of the economy, manufacturing, lost momentum in February, with the ISM manufacturing PMI weakening to a 2-year low of 54.2, and the forward-looking new orders weakening to 55.5 — a moderation, but not a catastrophic number. December too was a soft month for manufacturing (with new orders at 51.3) so this bears watching. But the cyclical component of the US economy is still likely to be growing at just below potential in 3Q 2019. The ISM non-manufacturing PMI hit a 3-month high of 59.7 and its new orders component soared to 65.2 — suggesting that the services sector in the US remains in rude health. The weak February NFP will likely mean the continuance of mild weakness for the US$ against Asian and EM currencies (less so against the Euro). The US economy remains on course to lose momentum in 2020, growing less than 2% for the year — with 2H 2020 growth likely to be closer to 1%. The US will narrowly avert recession in 2020, but the economy will not be strong enough to ensure Trump’s re-election. 

2. Global Capital Flows Show China’s Collapsing Export Markets Could Soon Revive

• Capital flows are strongly Granger causal
• Gross capital flows lead World shipping activity by 4 months
• Capital flows have been slowly rising since June 2018: in February they jumped
• Reinforces out pro-Asia and pro-China investment message

3. Understanding the Widening of the U.S. Trade Deficit

• The widening of the U.S. merchandise trade deficit to a record $891 billion in 2018 received considerable attention in the financial press this week but the criticisms that this widening represented either weakness in the U.S. economy or a failure of U.S. economic policy are misplaced.
• We expected a widening of the trade deficit in 2018 as a consequence of the tax cut and stronger economic growth.  Higher investment spending and a wider fiscal deficit were all but certain to lead to a larger trade gap.
• The dollar has firmed as the trade gap has widened over the last four years, which suggests the net overseas demand for U.S. assets has been rising faster than the current account deficit.

4. Weak February Payrolls But U.S. Labor Market Is Still Tightening

Nonfarm payrolls rose only 20,000 in February but the unemployment rate declined to 3.8% from 4.0%.  Average hourly earnings increased 0.4% and year-over-year wage growth picked up.  Monthly payroll changes are highly volatile and the three-month average of payroll growth is 186,000, which is still solid.  Also, most metrics show that the labor market tightened in February.

5. Philippines: February Inflation Eases Back to BSP’s Inflation Target Range

• Better-than-expected February inflation of 3.8%YoY wasn’t just a ‘base effect’ result. Broad food and transport CPI readings probably benefited from a year-ago, statistical high. It’s not the same for most of the non-food CPI items like rental & household utilities, and restaurant & miscellaneous goods & services that comprise discretionary expenditures. Lacking the base effect, inflation within this group seemed to have shed off last year’s price catalysts led by TRAIN’s excise hikes, high oil prices and supply shocks. 

• Based on the PSA’s seasonally adjusted data, headline inflation’s annualized pace was a benign 1.2%.

• Our updated monthly time series extrapolation showed headline inflation bottoming out at 1.3%YoY-1.4%YoY in September-October this year.

• Sustained liquidity tightness amid inflation’s benign pace with a trajectory settling in the BSP’s target range could facilitate a staggered bank reserve ratio cut of 2% starting 2Q19.   

• With the pro-growth bias of newly appointed BSP chief Benjamin Diokno (former Budget Secretary), the likelihood of a 25bp policy rate cut has been elevated in 3Q19 when inflation this year is expected to hit rock bottom and the ensuing size of positive, real interest rates could risk threatening growth.
• Considering potential macro upsides this year, e.g., inflation bottoming out alongside consumption recovery, buying risk assets on dips is still the norm.