The US labor market report for July and the gradual abandonment of Japan’s extreme monetary policy created a strong sell off widespread across different markets and across various asset classes around the world: stocks, bonds, currencies, cryptocurrencies and commoditieswhich was accentuated at the beginning of last week, to subsequently move towards a recovery and lower volatility.
We have already mentioned that global markets have been experiencing a general speculative bubble for several months, and that sooner or later some trigger would have to appear to generate a correction in asset prices. On this occasion, the main trigger was the increase in the unemployment rate in the United States. Recovery after a correction is also common, as we saw in the last few days of last week. Today, it cannot be said for sure that the correction is over.
The question that prevails over market volatility is whether we are close to or already in a recession phase, or whether the Fed’s target scenario of a soft landing will be fulfilled. It should be noted that in these scenarios what is being seen ahead is less economic activity, and that the scenarios are only perceiving a different intensity of high interest rates in economic activity, although there is also another factor of enormous weight, which is the fact that fiscal policy in more than 70 countries that held presidential elections this year will undergo a natural adjustment in 2025.
Focusing on the US economy, as in many other countries, recessions are detected or confirmed several months after they begin, due to the lag in the publication of economic data. The most widely accepted definition is that a recession is a phenomenon of widespread contraction of economic activity, and unemployment, for a prolonged period.
There are two main instruments in the United States that could be called timely indicators used to detect a recession in time. One of them is the inversion of the Treasury bond yield curve. The other indicator is the Sahm rule. Both indicators are signaling a recession. Are they right?
The yield curve consists of putting on a graph or in a table the yields of Treasury Bonds at different terms, from 3 months to 30 years, and observing the slope of this curve. Normally, and rationally, the slope is positive, and the higher the yield, the longer the term. When the slope becomes negative, that is, when you are paid more in short terms than in long terms, this is called an inverted curve.
The inverted yield curve of Treasury bonds appeared on this occasion from July 2022 to date. More than 730 days have already been accumulated with the negative curve, making this period the longest in history, preceded by a similar period of 624 days that occurred in 1978. Taking two-year bonds as analysis parameters, comparing them with 10-year bonds we have the following: At the beginning of 2021 there was a spread of +158.02 basis points of higher yield in 10-year bonds than the yield of the two-year bond. After crossing the two-year yield to the 10-year yield in July 22, in January 2023 the negative minimum of -104.47 is reached. As of last Friday, the negative spread is only -7.99 basis points. However, it should be noted that when this phenomenon preceded a recession (92 percent of cases), the recession begins when yield spreads become positive, which is about to happen.
The Sahm Rule, devised by former Federal Reserve economist Claudia Sahm, says that when the unemployment rate averages 0.5 percent above the 12-month low for a quarter, it means a recession is imminent — or has already begun. A few months ago, the unemployment rate hit 3.8 percent; now it is reported at 4.3 percent for last July. From 1953 to 2019, not counting the pandemic-driven recession, the Sahm Rule has worked 11 times, and on 10 of those occasions, the economy was already in recession. The only “misreading” of the rule was in 1959, when the recession began five months after the Sahm Rule was activated.
Finally, I would like to tell you that the increase shown by the timely indicator, the ISM for the services sector in July, which improved from 48.8 to 51.4 units in one month, is telling us that the domestic market in the United States is once again accelerating, which invalidates a diagnosis of recession already present, for the time being.
