Some Thoughts on the US Economy and Fed Policy

The US yield curve has inverted again even as US data has softened. This piece moves beyond our previous discussions about the predictive power of an inverted yield curve and instead focuses on which economic indicators that markets should watch for warning signs of recession.


The 3-month to 10-year US spread broke below zero in March but then moved back to positive in April. It has since inverted even deeper now, though we suspect it will continue to gyrate between negative and positive for some time before the argument is settled. The US economy is clearly going through a soft patch, and it remains to be seen whether it is temporary or something more ominous.

An inverted US yield curve has been the market bogey-man this past year. Why? The San Francisco Fed has shown the 3-month to 10-year spread to be the best predictor of a US recession. Studies suggest that inversion needs to be sustained for several months before a recession is triggered.

The good news is that the US yield curve inversion has been short-lived, at least so far. Equity markets are not yet pricing in a recession even as the bond markets suggests heightened risks. Which market is right? Only time will tell but our base case remains no US recession this year. We acknowledge that the impact of ongoing trade tensions is unpredictable and just the sort of exogenous shock that can tip an economy into recession.

Indeed, the breakdown of US-China trade talks and the announcement of higher tariffs on May 5 started the ball rolling. This was followed by weak US April retail sales data (-0.2% m/m headline) on May 15. Low inflation readings across the spectrum simply added fuel to the bond market rally, with today’s weak jobs data turning out to be the icing on the cake.


Source: Bloomberg


Markets are pricing in even more Fed rate cuts this year. The implied yield on the January 2020 Fed Funds futures contract is currently around 1.66%. This means that three cuts this year are pretty much fully priced in. Looking further out, the implied yield on the January 2021 Fed Funds futures contract is currently around 1.44%. This suggests that one more cut next year is fully priced in.

We do not expect a move at the next FOMC meeting June 19. However, Bloomberg’s WIRP model suggests a 26% chance of a cut at that meeting, up from around 6% at the start of last week. This 26% seems to overstate the case. Looking ahead, we acknowledge that the July 31 and September 18 meetings are live but totally data-dependent.


Source: Bloomberg


The Fed messaging has clearly shifted in recent days. Rather than stressing “patience” an “flexibility,” officials are now openly saying that rate cuts would be contemplated if the economic outlook were to worsen. Yet for the most part, the Fed (with the exception of Bullard) have played down the risks of recession. We tend to agree with them (see Economic Outlook below) and so we think the bar to a rate cut remains fairly high, at least for now.

Why? We do not think economic conditions have shifted that much over the past few months, only that the risks from the tariffs have risen. If the US can reach compromises with both China and Mexico in Q3 (our base case), the worst-case outcome may have been avoided. Under these circumstances, the US economy is likely to resume growing back near trend after this current soft patch. Meanwhile, US financial conditions (as measured by the Chicago Fed) are at record looseness despite the Fed’s nine rate hikes to date.

We can understand why the Fed might be reluctant to cut just yet. Part of it is bad optics. President Trump has been jawboning the Fed for lower rates. If he had just kept quiet, the Fed may have been on board with rate cuts sooner rather than later. Now, we think the Fed does not want to be seen as caving to Trump’s demands. The Fed is also correct to note that the impact of the tariffs have yet to be fully felt and so remains unknown.



The Chicago Fed National Activity Index (CFNAI) was first introduced in 2001. The index is a variation of earlier indexes and is a weighted average of 85 monthly US economic indicators. These indicators are broken down into four broad categories: 1) production and income, 2) employment, unemployment, and hours, 3) personal consumption and housing, and 4) sales, orders, and inventories. The index is constructed to have an average value of zero and a standard deviation of one. The scale is in standard deviations from trend growth.

The CFNAI should be viewed as a “Goldilocks” index. A value of zero shows an economy growing at trend. Positive values represent above trend growth, while negative values represent below trend growth. The game-changer in terms of analysis was the 2002 paper by Evans, Liu, and Pham-Kanter. Here, the authors formalized the use of threshold rules for the index to help identify recessions and inflationary episodes. Subsequent academic work identified threshold rules for the 3-month average known as CFNAI-MA3, which helps smooth out the highly volatile underlying monthly data.

Let’s look at the seven recessions identified by the National Bureau of Economic Research (NBER) over the period 1967-2019. In each of those seven cases, CFNAI-MA3 fell below the threshold value of -0.7 near the onset of recession. The only false signals occurred in July 1989 and December 1991/January 1992. While CFNAI-MA3 also provides useful signals about the likelihood of a sustained increase in inflation, we will leave that discussion to a more appropriate time in the future.

According to the Chicago Fed, the CFNAI has 95% accuracy in identifying US recessions and expansions. It also typically leads NBER recession calls by 6-18 months in real time, making it a very valuable indicator. From the Chicago Fed: “Specifically, the index first fell below the -0.7 threshold in the third month of the 198-82, 1990-91, and 2007-09 recessions. In the 1969-70, 1973-75, and 1980 recessions, the index fell below -0.7 in the second, 11th, and fourth months, respectively, while it fell below -0.7 one month prior to the start of the 2001 recession.”

As the chart shows, we have had numerous episodes of below-trend growth that has not devolved into recession. Right now, we believe the US economy is in one of those episodes with a negative reading, but it is not yet near the -0.7 threshold yet.


Source: Bloomberg, Chicago Fed



Our broad macro calls will be tested next week with another big data dump for the US. May PPI will be reported Tuesday, CPI Wednesday, and retail sales Friday. May auto sales came in stronger than expected at an annualized 17.3 mln pace, up from 16.4 bln in April.

Markets are disappointed that most inflation measures remain relatively low. Core PCE, the Fed’s preferred measure, fell to cycle low of 1.5% y/y in March before ticking up to 1.6% in April. It has been below the Fed’s 2% target all year. Headline CPI inflation rose to 2.0% y/y in April, the highest since November, while core CPI rose 2.1% y/y in April from 2.0% in March. The US 5-year TIPS breakeven rate is currently around 1.79%, up from the 1.49% trough from December but still quite low.

The Atlanta Fed’s GDPNow model is now tracking 1.4% SAAR for Q2, down from 1.5% previously. Elsewhere, the New York Fed’s Nowcast model is tracking 1.0% SAAR for Q2 vs. 1.5% the previous week. More importantly, we got its initial estimate for Q3 growth of 1.3% SAAR. Q2 data have clearly been on the soft side, but we note that Q1 also started off on a soft note before rebounding to 3.2% SAAR growth in the advance report (3.1% SAAR in the first revision). While a slowdown from Q1 was to be expected, markets will be particularly sensitive for signs of a larger than expected drop-off.

This week ended on a weak note for the data. The US economy only added 75k jobs in May vs. 175k expected, while the April gain was revised down from 263k to 224k. Average hourly earnings slowed to 3.1% y/y and was lower than expected. JOLTS data continue to show a tight labor market, with April data out Monday and expected to show further tightness. So where are the higher wages? Still, it’s worth noting that the labor market is a lagging indicator and has limited insight into the current state of the economy and the implications for Fed policy.

Markets are better off looking for a reliable leading or coincident indicator. For reasons explained above, we believe the Chicago Fed National Activity Index fits the bill. The 3-month average was -0.32 in April, the low for the cycle but still above the recessionary threshold of -0.7. The May reading will be reported June 24.

Other forward-looking indicators could help round out the picture. These include the ISM and Chicago PMI readings, which both came in better than expected in May. Nationally, new orders and prices paid improved from April. Consumer confidence measures can also be a useful indicator. But we go back to the fact that CFNAI captures many of these indicators already and also has a proven track record in signaling economic downturns.



For now, we are sticking with our broad macro calls. These include no US recession, a stronger dollar, higher equities, and a bearish steepening of bond yields. These hinge critically on our view that the trade wars will not trigger a US recession this year. All of these calls will be tested time and again all year and we expect heightened volatility across all markets in the coming months.

That is why the data has become so important. If the outlook changes and the economy slows significantly or even goes into recession, then the Fed will have no choice but to adjust its expected rate path significantly lower. We hope this paper helps investors enlarge their toolkits in order to help navigate these highly uncertain times.