The Capital Spectator

US Business Cycle Risk Report | 18 July 2019

How slow can it go before slipping into recession? Economic growth in the US has decelerated in recent months and there are new signs in today’s update that the macro trend is at risk of continuing to lose speed (gradually) in the months ahead. Thus the critical question: Where does the tipping point lie? Unclear, although the potential for trouble is creeping higher.

Using the latest numbers, today’s update shows that the slowdown continued to deteriorate (slightly) vs. last month’s update. Notably, the June profile’s near-term projection reflected the possibility of a mild reacceleration in growth. A month later, the prospect for a rebound in the trend has faded, based on today’s revised economic profile. As shown in the last chart below (Economic Trend Index: Actual Vs. Estimates), this month’s update reflects a fractionally softer outlook for the US economic trend, in the wake of the latest economic releases.

The good news is that an NBER-defined recession hasn’t started and is unlikely to kick in for the immediate future (through August). Looking into September and beyond is considerably less clear and so the possibility can’t be dismissed that the macro trend will deteriorate further in the final months of the year, perhaps to the point of triggering a new downturn.

For now, slow growth remains the working assumption, a view that’s based solely on the numbers published so far (along with some cautious modeling for projecting the missing data and looking ahead through August). Echoing this view is a nowcast for the upcoming second-quarter report on gross domestic product (due on July 26) that expects a substantially softer gain vs. Q1’s strong 3.1% advance. As reported by The Capital Spectator last week, the median estimate for Q2 GDP growth (based on a set of nowcasts) calls for a weak 1.7% increase. More recent estimates remain in line with that outlook, including yesterday’s revised GDPNow model (via the Atlanta Fed), which projects a sluggish 1.6% gain in output for the April-through-June period.

The best we can say at this point is that a new recession isn’t imminent. The analysis draws on a diversified set of indicators through June, based on The Capital Spectator’s proprietary business-cycle model. Analyzing the data in the table below through this lens still reflects a low probability that an NBER-defined downturn has started. (For a more comprehensive review of the macro trend with weekly updates, see The US Business Cycle Risk Report.)

For additional context, consider the aggregated profile of the indicators in the table above via two benchmarks. The Economic Trend Index (ETI) – a business-cycle index that tracks 14 indicators that collectively capture a broad snapshot of US economic activity – shows a renewed downside bias. ETI dipped slightly for June from the previous month, settling just above 71% (red line in chart below). This reading is still well above the 50% tipping-point mark (readings below 50% indicate recession). Note, however, that filtering the same data set through another econometric lens – the Economic Momentum Index (EMI) – reflects a weaker trend and one that appears to be deteriorating at a faster pace. EMI is still moderately above its 0% tipping point, but the downside bias is worrisome and deserves close attention in the weeks ahead. (For details on the design and interpretation of ETI and EMI, see my book on monitoring the business cycle.)

Using the data published to date for ETI, however, continues to offer a strong sign that recession risk remains low in the rear-view mirror. Translating the index’s historical values into recession-risk probabilities with a probit model points to low business-cycle risk for the US through last monthAnalysis through this lens indicates that the odds remain virtually nil — roughly 1% — that NBER will declare June as the start of a new recession. Note, too, that a probit-model reading of EMI (not shown) also shows a low probability (6%) that the economy was contracting last month.

Turning to the near-term outlook, consider how ETI may evolve as new data is published. One way to project values for this index is with an econometric technique known as an autoregressive integrated moving average (ARIMA) model, based on default calculations via the “forecast” package in R. The ARIMA model calculates the missing data points for each indicator for each month — in this case through August 2019. (Note that April 2019 is currently the latest month with a complete set of published data for ETI.) Based on today’s projections, ETI is expected to tick down in August, albeit to a level that still reflects modest economic growth.

Forecasts are always suspect, but recent projections of ETI for the near-term future have proven to be reliable guesstimates vs. the full set of published numbers that followed. That’s not surprising, given ETI’s design to capture the broad trend based across multiple indicators. Predicting individual components in isolation, by contrast, is subject to greater uncertainty. The assumption here is that while any one forecast for a given indicator will likely be wrong, the errors may cancel out to some degree by aggregating a broad set of predictions. That’s a reasonable view, based on the generally accurate historical record for the ETI forecasts in recent years.

The current projections (the four black dots in the chart immediately above) suggest that the economy will continue to expand through next month, albeit at a sluggish pace. The chart also shows the range of vintage ETI projections published on these pages in previous months (blue bars), which you can compare with the actual data (red dots) that followed, based on current numbers.

For more perspective on the track record of the ETI forecasts, here are the vintage projections for the past three months:

19 June 2019
21 May 2019
25 April 2019

Note: ETI is a diffusion index (i.e., an index that tracks the proportion of components with positive values) for the 14 leading/coincident indicators listed in the table above. ETI values reflect the 3-month average of the transformation rules defined in the table. EMI measures the same set of indicators/transformation rules based on the 3-month average of the median monthly percentage change for the 14 indicators. For purposes of filling in the missing data points in recent history and projecting ETI and EMI values, the missing data points are estimated with an ARIMA model.


Macro Briefing: 18 July 2019

Ebola outbreak in Congo declared a global health emergency: AP
US-China trade talks stuck in neutral: WSJ
US preparing to send troops to Saudi Arabia as Iran tensions rise: CNN
House kills impeachment vote on Trump: The Hill
GDPNow estimate of US Q2 growth remains at sluggish +1.6%: Atlanta Fed
Netflix reports first slide in US users in almost 10 years: WSJ
UK retail spending rebounded in June, surprising analysts: Reuters
Fed’s Beige Book survey reflects positive economic outlook: Bloomberg
1-year trend for US housing starts rebounded in June but permits stay negative:

Fed Chair Powell Vows To Support The US Expansion

It was far from the equivalent of Mario Draghi’s muscular “whatever it takes” comment in 2012, when the European Central Bank president famously outlined his resolve to save the euro. Yesterday’s comments from Federal Reserve Chair Jerome Powell were considerably more nuanced, in part because the US economy is in far better shape than the euro area, either in 2012 or today. Yet Powell’s remarks still serve as a reminder that US growth has slowed and so the Federal Reserve is focused on extending the expansion, which is set to become the longest on record at the end of this month.

Powell vowed to “act as appropriate” to keep growth alive, signaling that a rate cut is a possibility at the July 31 monetary policy meeting. Citing several potential threats to the economy, he said that “many FOMC participants judged at the time of our most recent meeting in June that the combination of these factors strengthens the case for a somewhat more accommodative stance of policy.”

The market is certainly expecting a rate cut. Fed funds futures continue to price in a virtual certainty that the central bank will reduce the current 2.25%-2.50% target rate on July 31 by either 25 or 50 basis points, based on CME data.

The prospect of a rate cut has perplexed some hawkish observers, who say that the economy is still expanding and so the need is weak for a new round of monetary stimulus. But some analysts counter that the Fed has learned to be more proactive. As The Economist notes this week:

Central banks’ tendency during expansions has long been to continue raising rates even after bad news strikes, cutting them only when it is too late to avoid recession. Before each of the last three American downturns the Fed continued to raise rates even as bond markets priced in cuts.

Can you teach an old dog new tricks? The answer may be clearer by the end of the month, depending on the Fed’s policy announcement. Meantime, the worrisome slide in inflation expectations in recent months appears, for now, to have subsided. That takes off some of the pressure to cut rates, if only slightly. For example, the yield spread for the 5-year nominal Note less its inflation-indexed counterpart rose to 1.63% yesterday (July 16). Although that’s still moderately below the Fed’s 2.0% inflation target, the current spread marks a rebound from a month ago, when the market’s implied inflation outlook was 1.45%.

Note, too, that official inflation data is showing signs of firming, if only marginally. The one-year core rate of consumer inflation ticked up in June to 2.1%, suggesting that the Fed has succeeded in keeping pricing pressure more or less steady at its target.

For the moment, inflation’s subdued but steady pace allows the central bank to focus on economic growth, or the lack thereof. As The Capital Spectator reported last week, the median estimate (via a set of nowcasts) for the upcoming second-quarter GDP report (scheduled for July 26) is on track to post a substantial slowdown in growth after Q1’s strong 3.1% increase. A week later, the outlook for Q2 data remains more or less the same. Yesterday’s update of the Atlanta Fed’s GDPNow model, for instance, projects that economic activity for Q2 will rise by a sluggish 1.6%.

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Analysts in support of rate cut are quick to note that parts of the Treasury yield curve are inverted, which implies that recession risk is elevated for the near term. Notably, the 10-year/3-month spread continues to be slightly negative. By contrast, the 10-year/2-year spread is still modestly positive, offering a counterpoint to those who say the curve’s recession signal is clear.

But the labor market still reflects strength. After stumbling in May, US payrolls bounced back in July, although the one-year trend for private employment continued to tick down. Yet jobless claims, a widely followed leading indicator, still signal strength. New filings for unemployment benefits remain close to a half-century low, suggesting that the US macro trend remains robust.

The data may be mixed, but the Fed looks set to err on the side of caution and take out a bit of insurance in favor of growth. “It still looks like the Fed will opt for 25bp rather than 50bp at the July meeting,” predicts Tim Duy, an economist at the University of Oregon who blogs frequently about central bank policy. “The message from Powell and others is that the primary motivation for a rate cut is a recalibration of policy considering greater downside risks while the underlying economy, in the words of Powell, remains in ‘a very good place.’”

If the Fed can extend the economic cycle into uncharted territory in terms of duration, it will be no small achievement. The US central bank has been widely criticized over the years for remaining blind to signs of slowing growth that turned into recession. Is this time different? Unclear, in part for the usual reasons, namely: real-time signals are always fuzzy for deciding if the economy is in a soft patch that will soon right or in the early stages of recession. Nonetheless, the possibility remains that the Fed has learned how to sidestep a recession. We are, perhaps, in the midst of a grand experiment in monetary policy. The outcome, however, remains a work in progress.

Is Recession Risk Rising? Monitor the outlook with a subscription to:
The US Business Cycle Risk Report

Macro Briefing: 17 July 2019

Will Washington sanction Turkey over Russian arms deal? CNBC
Big tech faced tough questions in Congress on Tuesday: AP
China and Vietnam remain in standoff over South China Sea dispute: Reuters
Japan-South Korea trade battle escalates: CNBC
Amazon faces European probe over 3rd party selling: WSJ
Import prices for the US fell in June by the most in 6 months: MW
Confidence among US home builders remained strong in July: HousingWire
Industrial output for US contracted in Q2: MW
US retail sales increased at moderate 3.4% annual pace in June:

Is Manufacturing’s Potency Fading For US Business Cycle Analysis?

There are no silver bullets in the search for early warnings of economic recession, but manufacturing activity has long been on the short list of key variables to watch. No surprise, given the mostly reliable tendency of output to stumble in this corner in the early stages of contraction, if not directly ahead of a downturn’s start. But that record looks challenged since the last recession, raising the question: Has manufacturing’s value as a business cycle indicator faded?

The current issue of The Economist entertains the possibility, noting that “a third of America’s 20th-century recessions were caused by industrial slumps or oil-price shocks, according to Goldman Sachs. Today manufacturing is just 11% of GDP and each dollar of output requires a quarter less energy than in 1999. Services have become even more vital, at 70% of output.”

Instead of fickle factories and Florida condos, investment has shifted to intellectual property, which now accounts for more than a quarter of the total. After the searing experience of 2008, the value of the housing stock is 143% of gdp, well below the peak of 188%. Banks are rammed full of capital.

The services sector offers the benefit of being less volatile, and so perhaps the business cycle fluctuations have become smoother. Only time will tell. Meantime, there are other risks that will no doubt conspire to create the next recession. The only mystery: will industrial activity play a central role on par with it’s history?

It’s unclear how many analysts, if any, are downplaying manufacturing’s influence on US recessions, but it’s likely that old habits die hard. Several years ago, for instance, a widely followed investor (a former hedge fund manager) outlined the case for elevating manufacturing to the top of the list for estimating business cycle risk. The Capital Spectator was skeptical of the advice (and remains so), primarily on the well-founded assumption that any one indicator’s value waxes and wanes through time in the cause of calling new recessions in real time. A more reliable system is tracking a diversified set of financial and economic indicators.

Learn To Use R For Portfolio Analysis
Quantitative Investment Portfolio Analytics In R:
An Introduction To R For Modeling Portfolio Risk and Return

By James Picerno

Manufacturing surely deserves to be on the list, but the last several years suggest that this piece of the economy’s business cycle signal has weakened. Consider how the Federal Reserve’s measure of the manufacturing component of US industrial output fares. As the chart below shows, manufacturing over the past half century has reliably fallen into negative year-over-year comparisons, either just ahead of NBER-defined recessions or shortly after the start of contractions. But since the last downturn ended in 2009, this metric has issued false signals.

For a clearer view of recent history, the next chart focuses on manufacturing’s one-year changes since 2014. Notice that the trend went negative twice in this period: for an extended period in 2015-2016 and ever so briefly and fractionally in April of this year. Although the US hit a soft patch in 2015-2016, it’s now clear that the economy didn’t slide into recession. The Capital Spectator’s multi-indicator business cycle model reflected the weakness at the time, although the real-time analysis consistently advised that recession risk remained a low probability (see the October 2015 and March 2016 updates, for instance).

The latest dip into negative terrain for manufacturing’s trend, so far, appears to be another false signal, although the final word has yet to be written, given that April was relatively recent and the economy has slowed over the last several months. The 2015-2016 slide, by contrast, is clearly a black eye for thinking that manufacturing is always and everywhere a reliable predictor of NBER recessions.

The lesson is a reminder that betting the farm on any one indicator is problematic for real-time recession-risk analysis. That includes the Treasury yield curve, which is currently “predicting” a recession in the near term, based on the negative spread between the 10-year Note’s rate less the 3-month T-bill yield. Here, too, history suggests a reliable record of anticipating US downturns. The question is whether this flawless record is now flawed?

No one knows, although skeptics point out that the extraordinary monetary policy over the past decade has degraded the yield curve’s signal. Note, too, that the widely followed 10-year/2-year spread has yet to go negative. In any case, it’s short-sighted to assume that the yield curve, manufacturing or any other one-indicator-wonder is the last word for estimating the probability that a recession is near (or has already started).

If only it were that easy. The reality is that developing reliable and timely recession signals requires a deeper dive. Most folks, by contrast, are looking for short cuts by focusing on one or two numbers to do all the heavy lifting.

In fact, history reminds that out-of-sample results tend to disappoint relative to in-sample modeling. One solution is to diversify the out-of-sample risk by using a carefully diversified set of indicators. The price tag, of course, is that the signal will likely arrive a bit later, but it’ll probably offer a higher degree of reliability. Note that you can improve the timeliness factor a bit by extrapolating nowcasts into the near-term future (no more than two to three months) by estimating a broad set of indicators (as an example, see the Actual vs. Estimates chart here, along with the accompanying analysis/description).

To be fair, manufacturing’s latest run of weakness, and/or the inverted yield curve, may prove to be accurate predictors of recession… or not. The issue is that in real time we don’t know which indicators will fail or succeed. The good news is that the uncertainty about single-indicator reliability can be minimized, to a degree, by focusing on a broad data set. By contrast, expecting a 30-second review of manufacturing or the yield curve, in isolation, to solve business cycle modeling challenges is the econometric equivalent of elevating faith over science.

Is Recession Risk Rising? Monitor the outlook with a subscription to:
The US Business Cycle Risk Report

Macro Briefing: 16 July 2019

Trump stokes outrage as he ramps up incendiary attacks on Dems: Politico
N. Korea: nuclear talks at risk over planned US-S. Korea war games: Reuters
Will the US-China trade conflict pinch Q2 corporate earnings? MW
Japan-S. Korea trade dispute represents new risk for global economy: CNBC
German economic sentiment remains deeply negative in July: ZEW
Can a non-economist succeed as chief of the European Central Bank? NY Times
Facebook’s crypto currency plan faces broad resistance: WSJ
NY Fed Manufacturing Index rebounds in July following steep decline in June: MW

Commodities Surged Last Week, Leading The Major Asset Classes

Broadly defined commodities topped last week’s performance ledger for the major asset classes – by a wide margin, based on a set of exchange-traded funds. Most of the gain was linked to higher oil prices, which rose due to a perfect storm of several bullish factors last week.

The iShares S&P GSCI Commodity-Indexed Trust (GSG) jumped 3.4% for the trading week through Friday, July 12. The rally lifted the fund to its highest close since late-May.

Several factors were behind the jump in commodity prices. A tropical storm that turned into a hurricane in the Gulf of Mexico triggered fears of a disruption in energy supplies in the region, which is critical for oil and gas production in the US. In addition, heightened geopolitical tensions between the US and Iran played a role in supporting energy prices. It didn’t hurt that last week’s June data on consumer inflation in the US posted slightly higher-than-expected results.

Learn To Use R For Portfolio Analysis
Quantitative Investment Portfolio Analytics In R:
An Introduction To R For Modeling Portfolio Risk and Return

By James Picerno

Last week’s weakest performer for the major asset classes: foreign stocks in developed markets. Vanguard FTSE Developed Markets (VEA) fell 0.5%, marking the ETF’s first weekly decline in a month.

Meanwhile, an ETF-based version of Global Market Index (GMI.F) continued to edge higher. This unmanaged benchmark, which holds all the major asset classes (except cash) in market-value weights, rose 0.8% — the sixth consecutive weekly gain for GMI.F.

For the one-year trend (252 trading days), US real estate investment trusts continue to lead the major asset classes. Vanguard Real Estate (VNQ) is up a solid 13.5% on a total return basis through last week’s close. The gain is moderately above the second-best one-year performer: US stocks via Vanguard Total Stock Market (VTI), which is up 9.2% for the trailing 12-month period.

Despite last week’s rally in commodities, the asset class remains the worst performer on a one-year basis. GSG lost 5.2% over the past year – the only negative print for the major asset classes for the trailing 12-month period as of last week’s close.

For a broadly diversified multi-asset class portfolio, by contrast, the one-year trend remains solidly positive. GMI.F is ahead by 6.3% on a total return basis for the trailing one-year window.

Bullish momentum continues to describe most of the major asset classes, based on the ETFs listed above. The upbeat profile is based on two sets of moving averages. The first compares the 10-day moving average with its 100-day counterpart — a proxy for short-term trending behavior (red line in chart below). A second set of moving averages (50 and 200 days) represents an intermediate measure of the trend (blue line). Using this data through last week’s close reveals that a bullish trend remains in force for nearly all of the funds.

Is Recession Risk Rising? Monitor the outlook with a subscription to:
The US Business Cycle Risk Report

Macro Briefing: 15 July 2019

China warns it will cut ties to US companies selling arms to Taiwan: Reuters
China’s GDP growth slips to 6.2% pace, lowest since 1992: SCMP
Commodities data is positive sign for China’s economic outlook: Bloomberg
Trump is considering removing Commerce Secretary Wilbur Ross: NBC
July survey of economists: US Q2 GDP growth set to decelerate to +1.9%: WSJ
China arrests another Canadian: Time
House considers barring tech firms from offering financial services: CNBC
US retail spending’s 1yr trend for June appears set to dip slightly to +3.0%:

Book Bits | 13 July 2019

The Code: Silicon Valley and the Remaking of America
Review via The New York Times
How an otherwise unexceptional swath of suburbia came to rule the world is the central question animating “The Code,” Margaret O’Mara’s accessible yet sophisticated chronicle of Silicon Valley. An academic historian blessed with a journalist’s prose, O’Mara focuses less on the actual technology than on the people and policies that ensured its success.
She digs deep into the region’s past, highlighting the critical role of Stanford University. In the immediate postwar era, Fred Terman, an electrical engineer who became Stanford’s provost, remade the school in his own image. He elevated science and engineering disciplines, enabling the university to capture federal defense dollars that helped to fuel the Cold War.

Replacing GDP by 2030: Towards a Common Language for the Well-being and Sustainability Community
By Rutger Hoekstra
Essay by author via WEF Live
GDP is the main attraction of the statistical world. It is used by all countries and GDP announcements are eagerly anticipated by markets, media and society. To paraphrase the novelist George Orwell – all statistics are equal but some statistics – such as GDP – are more equal than others.
While GDP is generally accepted as a proxy indicator for the “success” of a nation, it is also widely criticized, often for the fact that that it ignores important factors such as the wellbeing of citizens, levels of inequality and the health of the environment. Furthermore, the GDP methodology has been revised only four times in the last 70 years, which can raise doubts about whether it has kept pace with rapid developments in the globalized and digitized economy.

Coders: Who They Are, What They Think and How They Are Changing Our World
By Clive Thompson
Q&A with author via The Verge
Between never-ending Facebook scandals and debates over fake news and polarization, the general public seems to be more aware than ever of the extent to which software governs our daily lives. “People are unsettled by it, but they still don’t know anything about how the software came to be and why these creators decided to tackle these problems and build these tools,” says Clive Thompson, a technology journalist and author of Coders: The Making of a New Tribe and the Remaking of the World.
“There’s always this mystery behind the people who actually make the software, and at the same time there has historically been a pretty inaccurate vision that comes out of Hollywood and TV,” Thompson says. He became intrigued not just by the software itself and the environment that created it, but by the type of person who gets sucked into this world: “I really wanted to give the average person a glimpse at the priorities and dreams and blind spots of the people that are making the tools that are going wrong.”

Democracy in Crisis: The Neoliberal Roots of Popular Unrest
By Christian Lammert and Boris Vormann
Summary via publisher (University of Pennsylvania Press)
Liberal democracies on both sides of the Atlantic find themselves approaching a state of emergency, beset by potent populist challenges of the right and left. But what exactly lies at the core of widespread dissatisfaction with the status quo? And how can the challenge be overcome In Democracy in Crisis, Christian Lammert and Boris Vormann argue that the rise of populism in North Atlantic states is not the cause of a crisis of governance but its result. This crisis has been many decades in the making and is intricately linked to the rise of a certain type of political philosophy and practice in which economic rationality has hollowed out political values and led to an impoverishment of the political sphere more broadly. The process began in the 1980s, when the United States and Great Britain decided to unleash markets in the name of economic growth and democracy. After the fall of the Berlin Wall, several countries in Europe followed suit and marketized their educational, social, and healthcare systems, which in turn increased inequality and fragmentation. The result has been a collapse of social cohesion and trust that the populists promise to address but only make worse.

The Rise of Finance: Causes, Consequences and Cures
by V. Anantha Nageswaran and Gulzar Natarajan
Summary via publisher (Cambridge University Press)
Financialisation, or the disproportionate importance of financial considerations in economic decisions, has been a defining feature of the economic history of the last twenty-five years. The wave of deregulation that accompanied the neoliberal agenda in the US, aided by the dominance of US dollar and American economy, has resulted in the globalisation of finance. This book examines the rise of financialisation globally, while charting its drawbacks and prescribing suggestions for a definitive overhaul of the structure. Bringing together various strands of the latest research and evidence generated in recent years, empirical analysis, and views of reputed experts in the field, it presents a counter-point to the canonical ideas of analysing financial market dynamics and financial globalisation. It proposes a revision of the current monetary policy paradigm to correct its excessive focus on equity markets and their ‘wealth effect’, embrace a more symmetric response to the economic cycle, and a mandate to focus on financial stability as much as price stability.

Go Fund Yourself: What Money Means in the 21st Century, How to be Good at it and Live Your Best Life
By Alice Tapper
Review via Financial News
Alice Tapper wants young people to live their “best financial life”.
The twenty-something economist and former financial services worker — first at accounting firm EY and then as a freelance consultant for fintech companies — has written a personal guide, Go Fund Yourself: What Money Means in the 21st Century. In it, Tapper says she wants to “throw in the old generational tropes about avocado toast eating away your house deposit” and inspire millennials to take control of their finances.

Digital Transformation: Survive and Thrive in an Era of Mass Extinction
By Thomas M. Siebel
Summary via publisher (Rosetta Books)
The confluence of four technologies — elastic cloud computing, big data, artificial intelligence, and the internet of things — writes Siebel, is fundamentally changing how business and government will operate in the 21st century. Siebel masterfully guides readers through a fascinating discussion of the game-changing technologies driving digital transformation and provides a roadmap to seize them as a strategic opportunity. He shows how leading enterprises such as Enel, 3M, Royal Dutch Shell, the U.S. Department of Defense, and others are applying AI and IoT with stunning results.

Research Review | 12 July 2019 | Yield Curve Analysis

Yield Curve and Financial Uncertainty: Evidence Based on Us Data
Efrem Castelnuovo (University of Melbourne)
June 2019
How do short and long term interest rates respond to a jump in financial uncertainty? We address this question by conducting a local projections analysis with US monthly data, period: 1962-2018. The state-of-the-art financial uncertainty measure proposed by Ludvigson, Ma, and Ng (2019) is found to predict movements in interest rates at different maturities. In particular, an increase in financial uncertainty is found to trigger a negative and significant response of both short and long term interest rates. The response of the short end of the yield curve (i.e., of short term interest rates) is found to be stronger than that of the long end (i.e., of long term ones). In other words, a financial uncertainty shock causes a temporary steepening of the yield curve. This result is consistent, among other interpretations, with medium-term expectations of a recovery in real activity after a financial uncertainty shock.

Why Does the Yield-Curve Slope Predict Recessions?
Luca Benzoni (Federal Reserve Bank of Chicago), et al.
December 2018
Why is an inverted yield-curve slope such a powerful predictor of future recessions? We show that a decomposition of the yield curve slope into its expectations and risk premia components helps disentangle the channels that connect fluctuations in Treasury rates and the future state of the economy. In particular, a change in the yield curve slope due to a monetary policy easing, measured by the current real-interest rate level and its expected path, is associated with an increase in the probability of a future recession within the next year. In contrast, a decrease in risk premia is associated with either a higher or lower recession probability, depending on the source of the decline. In recent years, a decrease in the inflation risk premium slope has been accompanied by a heightened risk of recession, while a lower real-rate risk premium slope is a signal of diminished recession probabilities. This means that not all declines in the yield curve slope are bad news for the economy, and not all instances of steepening are good news either.

Deconstructing the Yield Curve
Richard K. Crump (NY Fed) and Nikolay Gospodinov (Atlanta Fed)
April 1, 2019
We investigate the factor structure of the term structure of interest rates and argue that characterizing the minimal dimension of the data-generating process is more challenging than currently appreciated. To circumvent these difficulties, we introduce a novel nonparametric bootstrap that is robust to general forms of time and cross-sectional dependence and conditional heteroskedasticity of unknown form. We show that our bootstrap procedure is asymptotically valid and exhibits excellent finite-sample properties in simulations. We demonstrate the applicability of our results in two empirical exercises: First, we show that measures of equity market tail risk and the state of the macroeconomy predict bond returns beyond the level or slope of the yield curve; second, we provide a bootstrap-based bias correction and confidence intervals for the probability of recession based on the shape of the yield curve. Our results apply more generally to all assets with a finite maturity structure.

The Inverted Curve and Recession: A Hoax, When It Ends?
Yosef Bonaparte (University of Colorado at Denver)
June 17, 2019
The paper shows that the chance inverted curve predicts recession is less than 3.9%, and even not statistically significant. But then we ask why investors still see linkage between inverted curve and recession? The behavior psychology research demonstrates that, for the majority, bad events (such as the 2007 event) register stronger and longer than good events, and vivid in investors’ memory. Finally, we show that the strongest and best predictor for recession is the current GDP growth.

Does the Yield Curve Really Forecast Recession?
David Andolfatto (St. Louis Fed) and Andrew Spewak
November 30, 2018
Does the recent flattening of the yield curve portend recession? Not necessarily. The flattening of the real yield curve may simply reflect the fact that real consumption growth is not expected to accelerate or decelerate from the present growth rate of about 1 percent year over year. On the other hand, a 1 percent growth rate is substantially lower than the U.S. historical average of 2 percent. Because of this, the risk that a negative shock (of comparable magnitude to past shocks) sends the economy into technical recession is increased. While the exact date at which the shock arrives is itself unpredictable, the likelihood of recession is higher relative to a high-real-interest-rate, high-growth economy.

Empirical Analysis and Forecasting of Multiple Yield Curves
Christoph Gerhart and Eva Lütkebohmert (University of Freiburg)
January 8, 2019
In this paper we develop new dynamic factor models to forecast multiple yield curves. Our methodology is based on a thorough empirical study of daily tenor-dependent term structures over the time period 2005-2017 which reveals important cross-tenor dependencies of yields. The suggested forecasting approach accounts for these dependencies and thus targets the new features of post-crisis interest rate markets. Our method generates extremely precise predictions of future yield curves for various forecasting horizons. In particular, it clearly outperforms existing single-curve forecasting methods which naturally omit any connections between rates of different tenor structures.

Downturns and Changes in the Yield Slope
Mirko Abbritti (University of Navarra), et al.
September 8, 2018
We show that the slope of the sovereign yield curve not only predicts future economic activity through its level but also through its changes. Our results with US data show that the inclusion of the first difference of the slope in the traditional yield slope regressions significantly increases the explanatory power of the yield curve. Decomposing the yield slope changes into those of the risk-neutral spread and of the term premium also brings insights into future economic activity forecast. We find that, while positive changes to the risk-neutral spread predict lower economic activity in the short-run (1-3 months), positive changes to the term premium predict lower economic activity in the medium run (3-12 months). These results are obtained at both monthly (industrial production, unemployment) and quarterly (GDP growth, unemployment) frequencies and also in probit-type recession regressions.

(Don’t Fear) The Yield Curve
Eric Engstrom and Steven Sharpe (Federal Reserve)
June 28, 2018
In this note, we show that, for predicting recessions, such measures of a “long-term spread”–the spread in yields between a far-off maturity such as 10 years and a shorter maturity such as 1 or 2 years–are statistically dominated by a more economically intuitive alternative, a “near-term forward spread.” This spread can be interpreted as a measure of the market’s expectations for the direction of conventional near-term monetary policy. When negative, it indicates the market expects monetary policy to ease, reflecting market expectations that policy will respond to the likelihood or onset of a recession. By that token, the current level of the near-term spread does not indicate an elevated likelihood of recession in the year ahead, and neither its recent trend nor survey-based forecasts of short-term rates point to a major change over the next several quarters.

Dissecting the Yield Curve: The International Evidence
Andrea Berardi (Ca Foscari University of Venice) and A. Plazzi (Swiss Finance Inst.)
June 18, 2019
Using a stochastic volatility affine term structure model, we explicitly consider the interrelation between yield curves and macro and volatility factors. We provide estimates of short rate expectations, term premium and convexity of nominal yields and for their real and inflation components for four different currency areas: US, Euro Area, UK, and Japan. We find that in all areas there are non-negligible convexity effects in correspondence with high volatility periods, and that term premium and convexity explain a significant proportion of the dynamics at the long end of the yield curve. Using panel regressions, we show that, overall, short rate expectations are procyclical while term premia exhibit a countercyclical behaviour and tend to increase with yield volatility. We also detect strong cross-country co-movements both in short rate expectations and term premia, with the degree of connectedness exhibiting significant time variation.

Macro Briefing: 12 July 2019

Tropical storm forces evacuations in Louisiana: WSJ
Tariffs pinched China’s exports in June: Reuters
No sign of easing tensions in US-China trade battle: Bloomberg
Eurozone industrial output rose more than expected in May: FT
Turkey receives first shipment of controversial Russian missile system: NY Times
Oil glut expected to return in 2020, IEA predicts: CNBC
US jobless claims fell to 3-month low last week: Bloomberg
Core consumer inflation in US unexpectedly ticked up to +2.1% in June:

Will Lowflation Extend The Rally In Everything For Bonds?

Federal Reserve Chairman Jerome Powell testified in Congress yesterday that a rate cut may be near. That’s music to the ears of the bond market because it offers more fuel for extending the rally in fixed-income assets.

Every major slice of the US bond market is posting year-to-date gains, based on a set of ETFs, and the prospect of a rate cut suggests that the strong appetite for fixed-income assets will endure for the foreseeable future. Leading the way for 2019’s rally: long-term corporate bonds.

Vanguard Long-Term Corporate Bond (VCLT) closed yesterday (July 10) with a sizzling 15.6% year-to-date total return. The gain marks the best advance, by far, among the main components of the US bond market this year. Indeed, the second-best performer so far in 2019 — SPDR Bloomberg Barclays High Yield Bond (JNK) – is up 10.9% this year: a solid rally, but no match for VCLT’s surge.

In a sign of the times, an ETF that represents a broad measure of all investment-grade US debt securities — Vanguard Total Bond Market Index Fund ETF Shares (BND) — is also sitting on a tidy year-to-date increase of 6.0%.

A key factor in the broad-based bond market rally is subdued inflation. Fixed-income investors live in perpetual fear that the purchasing power for the set-in-stone payouts that fixed-income securities generate will be eaten away by rising inflation. But that’s become a dormant risk in recent years, courtesy of inflation’s big fade of late.

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Core inflation for consumer prices, for example, is currently rising at 2.0% on an annual basis through May, which matches the Fed’s inflation target. Headline CPI (which includes energy and food) is even softer, advancing by just 1.8%. Today’s inflation update for June is expected to report more of the same. Core CPI is on track to hold steady at 2.0% and headline pricing pressure will dip to 1.6%, based on’s consensus forecast. In other words, the lowflation gravy train for bonds is set to roll on for the near term, and perhaps longer.

Powell’s testimony yesterday aligns with the lowflation expectations, at least for the immediate future. “Our baseline outlook is for economic growth to remain solid, labor markets to stay strong, and inflation to move back up over time to the committee’s 2% objective,” Powell said in prepared remarks. “However, uncertainties about the outlook have increased in recent months.”

It’s those uncertainties that keep the bond market humming. All the more so with expectations that economic growth is slowing. As reported earlier this week by The Capital Spectator, the upcoming second-quarter report for US gross domestic product is on track to reflect a sharp deceleration in output, based on the median estimate for a set of nowcasts.

Not surprising, Powell’s latest comments have been widely interpreted as laying the groundwork for a rate cut at the July 31 policy meeting. In turn, that implies higher bond prices, which move inversely with interest rates. Fed funds futures are currently pricing in a near certainty that the central bank will trim its target rate, according to CME data.

Meanwhile, the Treasury market’s implied inflation forecast continues to anticipate that pricing pressure will remain below the Fed’s 2.0% target. The spread on the 5-year nominal Note less its inflation-indexed counterpart, for example, is currently projecting inflation at slightly less than 1.6%.

The market, in sum, anticipates that macro conditions will remain favorable for fixed-income assets. But not everyone’s drinking the Kool-Aid.

“Markets can make mistakes. The bond market may have over-reacted. That does worry me,” advises Colin Harte of the multi-asset solutions team at BNP Paribas Asset Management. “A lot of people have expectations of central banks being very accommodative and sensitive to financial markets. There’s a danger in that.”

Perhaps, but at the moment the crowd is in a celebratory mood and pricing bonds as if the potential for inflation danger in the near term is virtually nil. Indeed, a measure of momentum in the fixed-income market continues to reflect something approximating nirvana, based on two measures of the price trend for the funds listed above.

The first metric compares each ETF’s 10-day moving average with the 100-day average — short-term trending behavior (red line in chart below). A second set of moving averages (50 and 200 days) offers an intermediate measure of the trend (blue line). The indexes range from 0 (all funds trending down) to 1.0 (all funds trending up). Using prices through yesterday’s close shows that all the bond ETFs remain in a strong bullish posture. The implication: the rally in everything still has room to run.

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Macro Briefing: 11 July 2019

Iranian boats attempt to intercept British tanker: BBC
Flood risk rises for millions as Gulf of Mexico storm threatens: CNN
Oil rises to 6-week high on Iran tensions, Gulf of Mexico storm: Reuters
Fed’s Powell tells Congress that central bank is ready to cut rates: WSJ
Former US ambassador to China: tariffs on China are ‘new normal’: CNBC
Business inflation expectations dip to 1.9%, matching a 2yr low: Atlanta Fed
US gov’t set to arrest and deport thousands of illegal immigrants: NY Times
Fed minutes support case for rate cut: Bloomberg
US core inflation’s 1yr trend for June on track to ease in today’s update:

Can You Minimize Regret By Analyzing Return Distributions?

In the grand scheme of investing, behavioral risk is second to none on the list of pitfalls that threaten to derail the best-laid plans for investing. The challenge is especially acute in the thankless task of trying to anticipate how you’ll react when a rough patch arrives. The mystery is all the deeper if your only experience with a fund or strategy is holding it during a bull market. There are no easy solutions to this problem, but you can start to chip away at the uncertainty with a simple round of econometric analysis that focuses on return distributions.

Alpha Architect’s Wes Gray describes this technique as “one way to assess the behavioral challenge.” Although he uses distributions in the article to analyze a trend-following strategy for several country benchmarks, the concept can be applied to any portfolio. As an example, let’s run the numbers on a pair of simple stock/bond strategies.

For a benchmark, let’s use the US stock market, based on the Vanguard 500 Index Fund (VFINX). In this toy example, the goal is to consider how a 60% stocks/40% bonds mix will fare against the benchmark. In particular, how will the results diverge? Presumably, the stock/bond strategy will be smoother. Let’s put some hard numbers to the test by studying the past and comparing VFINX with the 60%/40% portfolio.

To build the stock/bond strategy we’ll use VFINX for the 60% equity weight and Vanguard Total Bond Market (VBMFX) to represent the 40% allocation to US fixed income. The start date is the end of 1998, with year-end rebalancing to the target weights. In the interest of brevity, we’ll limit the analysis to rolling one-year returns for the past two decades, although in practice you should consider longer time windows and earlier start dates.

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In the first chart below, it’s clear that the 60/40 strategy (red line) offers a degree of improvement over a straight buy-and-hold investment in US equities (VFINX). The 60/40 portfolio’s suffers a lower frequency of one-year losses while the distribution of gains tends to match/exceed the stock market’s results. In short, this looks like a win-win situation, assuming your focus is on rolling one-year periods (and you’re willing to take a leap of faith and accept the past 20 years as gospel).

Can we do better? Probably, although the possibilities are endless. Where to start? For an illustration, let’s consider one other possibility: splitting the 60% equity allocation evenly between US and foreign funds via 30% in VFINX and 30% in Vanguard Total International Stock (VGTSX), with the 40% bond weight remaining in VBMFX. We’ll label this strategy: 30/30/40. As before, the portfolio is rebalanced to the target weights every December 31.

The results, shown by the blue line in the next chart below, remind that adding foreign equities has been a drag on performance vs. a US-only focus in recent years. Indeed, the 30/30/40 strategy posted a moderately higher frequency of one-year losses with similar results (at best) for frequency of gains.

Finally, let’s review the distribution of the performance spread for the 60/40 and 30/30/40 strategies. The third chart below reflects the rolling one-year returns for 30/30/40 less 60/40. This view offers a relative comparison of the two strategies via a one-year prism. Another way to think about the chart below: it quantifies the differences in the red and blue lines in the chart above.

The main takeaway in the chart below: the one-year return distribution is skewed to the left (negative returns). In other words, there’s a bias for underperformance for the 30/30/40 strategy relative to 60/40.

It’s short-sighted to assume that international equity allocations will continue to be a drag on performance. But if we were confident that the past 20 years was a reliable gauge of the future (a heroic assumption in this case), the charts above suggest that sticking with the 60/40 mix will offer a smoother ride and stronger returns.

Granted, studying a 60/40 strategy through a return-distribution lens doesn’t offer a deep level of perspective beyond intuition. All the more so by limiting the analysis to one-year returns. But profiling performance through distributions for more sophisticated strategies is more likely to turn up surprising insights. Indeed, the more you dive into a customized asset allocation and use a broader set of asset classes, the less you know about the return distribution – until you start crunching the numbers.

In fact, you can and should run distribution analysis for risk metrics too. Reviewing how volatility, Sharpe ratio, Sortino ratio, etc. stack up can help minimize the ambiguity of how a given strategy will perform in the future from a risk perspective. And if you’re truly ambitious, you can also generate expected returns and risk data as inputs for distribution analysis.

Alas, it’s still impossible to predict the future. But by laying out distributions on return and risk for a strategy, you can estimate how the portfolio could vary going forward. In turn, you’ll have some data to explore for trying to predict if you’ll be able to stay the course – or not — when the road turns rocky.

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Macro Briefing: 10 July 2019

Trump is looking for ways to weaken US dollar: Bloomberg
US plans to form int’l coalition to patrol Strait of Hormuz and nearby waters: BBC
Will Fed adjust policy based on trade issues? Reuters
Trump softened tone on China’s handling of Hong Kong to revive trade talks: FT
Mexico’s finance minister quits, citing policy disputes with president: WSJ
China’s inflation held at a 15-month high in June: SCMP
US job openings eased in May but remain near record high: MW

US Q2 GDP Outlook Stumbles Ahead Of This Month’s Initial Report

With less than three weeks before the government publishes its preliminary estimate of second quarter economic data, revised nowcasts have trimmed expectations for US output. Today’s estimate calls for a substantial slowdown in Q2 growth, based on a set of projections compiled by The Capital Spectator. The downgrade for the GDP nowcast comes at a time of concern that recession risk, for the US and the global economy, is rising.

Economic activity for the US is on track to expand by a sluggish 1.7% in Q2, according to the median for a set of nowcasts. The projection marks a conspicuous drop from the 2.0% gain in the previous nowcast update for Q2 (June 25). The slide is all the more notable because it follows a period of stable median GDP projections for the current quarter. Although today’s estimate still shows that the US will skirt a recession in the April-through-June period, the deceleration in growth following Q1’s strong 3.1% gain raises a warning flag for this year’s second half and beyond.

Nonetheless, there’s still a case for expecting that US output will remain strong enough to avoid an NBER-defined recession, based on numbers published to date. As noted in the June business-cycle profile (and reaffirmed in this week’s edition of The US Business Cycle Risk Report), the recent slowdown appears to be stabilizing. The only difference now is that the stabilization is on track to settle at a pace that’s weaker than previously estimated.

If today’s median estimate is accurate, Q2 GDP growth is set to weaken the most since 2015’s third quarter — the last time that elevated recession fears stalked the macro landscape for the US. It turned out to be a false alarm then and that’s still the likely outcome, based on a broad range of data published to date.

But there are also reasons that suggest otherwise. One high-profile indicator that’s fueling concern is the ongoing inverted yield curve for 10-year less 3-month Treasuries. This spread has been negative (10-year below 3-month rate) since late-May — a warning that’s widely considered a harbinger of an upcoming recession.

Yet the 10-year/2-year gap is still modestly positive, suggesting that the Treasury market’s economic outlook remains mixed.

Although the outlook is cloudy and growth expectations have taken a hit, it’s still premature to assume that a new recession is fate. A partial or full resolution to the US-China trade war in the weeks ahead could lift economic activity. Meantime, Fed funds futures are pricing in a near certainty that the Federal Reserve will cut interest rates later this month, at the July 26 FOMC meeting. Easier monetary policy may provide a modest boost to growth.

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Nonetheless, the decelerating macro trend is conspicuous. In line with recent projections, the one-year GDP growth trend for the US is still on track for a gradual slide, based on The Capital Spectator’s average point estimates via a set of combination forecasts. Today’s revised point forecast advises that the year-over-year rate of growth will ease for several quarters going forward. The good news: the near-term outlook still anticipates that growth will remain strong enough to keep recession risk low. But if this turns out to be overly optimistic and the one-year GDP growth rate falls closer to 1%, the outlook will turn considerably darker.

Meantime, the crowd is on alert for additional slow-growth warnings. The US expansion, set to become the longest on record at the end of this month, will likely roll on for the near term. But the recent downshift has raised the stakes for incoming data and so a new round of downside surprises on key indicators could deliver a significant attitude adjustment in the weeks ahead.

For now, Wall Street is banking on support from the Federal Reserve, an expectation that will be tested in Fed Chairman Jerome Powell’s testimony to Congress today and tomorrow.

“Powell has made it clear that, if necessary, the Fed will take steps to assure the continuation of the expansion,’’ says Ward McCarthy, chief financial economist at Jefferies. “What is not clear is what would trigger the Fed take these steps. I am looking for him to provide some clarity.’’

Learn To Use R For Portfolio Analysis
Quantitative Investment Portfolio Analytics In R:
An Introduction To R For Modeling Portfolio Risk and Return

By James Picerno

Macro Briefing: 9 July 2019

US and China set to relaunch trade talks: Reuters
Wall Street wonders if US will pursue weak-dollar policy: Bloomberg
US lawmakers don’t share Trump’s criticism of Fed chief: WSJ
Hong Kong’s leader says controversial extradition bill is dead: CNBC
Are central banks prepared to fight a global recession? NY Times
Rental demand soars at the expense of home buying: CNBC
US consumer credit expanded in May for second month: MW
10yr/3mo Treasury yield curve remains negative for 7th week:

A New Column…

In addition to the day job here at The Capital Spectator, your editor is now a contributing writer for a series of columns for The Milwaukee Company on risk, portfolio management and the usual suspects that generally fall under the heading of the money game. The agenda is broad, the raw material for analysis is endless, and the journey still begins with a first step. In this case, it’s a brief primer on applying basic risk metrics to portfolios in the cause of separating the wheat from the chaff.

US, Foreign Real Estate Shares Topped Market Returns Last Week

Property shares in the US and offshore markets posted the biggest gains for the major asset classes in the first week of trading for the third quarter, based on a set of exchange-traded funds.

US real estate investment trusts (REITs) led the way via Vanguard Real Estate (VNQ), which popped 2.5% for the trading week ended July 5. Foreign real estate shares were in close pursuit: Vanguard Global ex-U.S. Real Estate (VNQI) gained 2.0%, rising to its highest weekly close since early 2018.

Foreign bonds posted the biggest losses last week. The steepest setback was in SPDR Bloomberg Barclays International Treasury Bond (BWX), which shed 0.7%. The decline marks the first weekly loss for the ETF in three weeks.

Foreign corporates suffered the second deepest loss last week. Invesco International Corporate Bond (PICB) shed 0.5%.

Learn To Use R For Portfolio Analysis
Quantitative Investment Portfolio Analytics In R:
An Introduction To R For Modeling Portfolio Risk and Return

By James Picerno

Meanwhile, an ETF-based version of Global Market Index (GMI.F) continued to rise last week. This unmanaged benchmark, which holds all the major asset classes (except cash) in market-value weights, added 0.8% — the fifth consecutive weekly gain for GMI.

For the one-year trend (252 trading days), US real estate investment trusts are still leading the major asset classes, although the margin of leadership has narrowed lately. Vanguard Real Estate (VNQ) is up a solid 14.6% on a total return basis through last week’s close.

In second place: US equities. Vanguard Total Stock Market (VTI) posted a 10.8% total return at last week’s close.

Commodities continue to suffer the biggest — the only — loss for the trailing one-year window for the major asset classes. GSG is down 11.6% over the past 12 months.

For markets overall, the one-year trend is still comfortably positive. The weighted benchmark for global assets – GMI.F – is currently posting a healthy 7.2% total return for the year through July 5.

Price momentum for the major asset classes continues to skew positive overall, based on the ETFs listed above. The analysis reflects two sets of moving averages. The first compares the 10-day moving average with its 100-day counterpart — a proxy for short-term trending behavior (red line in chart below). A second set of moving averages (50 and 200 days) offers an intermediate measure of the trend (blue line). On this basis, as of last week’s close, a majority of funds reflects a bullish trend.

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Macro Briefing: 8 July 2019

Strong US jobs growth report undermines case for rate cut: CNBC
Trump rolls out more criticisms of Federal Reserve: Bloomberg
Greece elects conservative gov’t, pledging tax cuts, investment: Reuters
Turkish lira weakens after central bank chief is fired: CNBC
Deutsche Bank announces huge layoffs and restructuring plans: WSJ
German industrial output rebounded but yoy change sinks deeper into red
US payrolls rebounded sharply in June: CNBC
1yr trend for US industrial/commercial loans slipped to 6mo low in May: