Citi Research analysts say the probability of a recession in the US has risen to an uncomfortable level, although it’s not Citi’s base case, and say Fed Chair Powell seems to consider that outcome likely.
Market signals look to be broadly in line with a recession outcome, with early next year a plausible timeframe.
Citi Research analysts have previously made the case that the Fed has never brought down significantly elevated inflation without a recession, as the following table shows.
Very hard to carry out meaningful disinflation without a recession
While a recession is not the base case of Citi Research economists, they note that Fed chief Powell suggested recently that a recession may be likely.
In his interview on May 17, the Fed Chair sounded resigned to the fact that the Fed may have to tighten enough to cause a recession. At his most optimistic, he talked about a “soft-ish” landing; at his most pessimistic, he spoke about possible pain in the labor market. These comments further underline that the hurdle for the Fed to switch from its fight against inflation towards fighting economic weakness is very high, though Citi Research analysts point out that they’re not sure the market needed much additional evidence.
Yield curve in line with recession view
The two main market indicators relevant for a recession call are curve-inversion and a move up in credit spreads. On the inversion side, analysts note that 2s/10s did invert, if only very briefly. But this is not necessarily uncommon. In some of the past recession episodes, the inversion was also short-lived, and curves had steepened by the time the recession occurred. While analysts also note that this dis-inversion typically happened because the Fed turned less hawkish, or sometimes outright dovish, it is plausible that this time around some steepening happens early due to QT. In any case, by the way it is going, they say we may see a re-inversion sooner rather than later.
Credit is also concerning.
US HY sold off around 400bp in both 2008 and 2001 before the start of the US recession and 70bp in 2020, when the recession onset was a complete surprise. This time around, the sell-off has been only around 160bp since the trough in April. But, given that a recession is unlikely to start in the next six months, it could be seen that, broadly speaking, that credit spreads are consistent with a coming recession.
EM credit typically does not fare well as recessions approach. For EM credit, there are only three data points. Overall, the stylized facts are that spreads are also widening into the recession. The widening starts around six months before the recession. A lot of the widening only happens afterwards, though, especially in the case of the pandemic recession, which gave little advance warning. The impact in 2007 on EM was also delayed, as it took some time for the US banking sector weakness to filter through to the rest of the world.
EM credit widens around six months before the recessions onset.
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Source: Citi Research, Yieldbook, Bloomberg
The headwinds to global growth have clearly intensified as central banks, arguably behind the curve, return to their price stability mandate and expeditiously tighten monetary policy. Meanwhile, the spread of Omicron in China has led to another downward global growth revision, while high inflation surprises justify further upward adjustments to inflation forecasts.
Improvements in supply bottlenecks and lower commodity prices next year could help avoid a scenario where monetary policy tightening causes a recession. However, the upside inflation risks will keep recession probabilities elevated in the near-term
For more in depth analysis of the global economy, please see Emerging Markets Strategy Weekly - On Recession Watch and Global Economic Outlook & Strategy - Central banks need to remain focused on achieving price stability
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