Is a U.S recession on the cards?

by Sean Tweedie | September 1, 2022

U.S recessionary fears continue to dominate markets with the result that the overriding sentiment, particularly within the foreign currency market, continues to be risk-off. Despite these recessionary fears investor sentiment increased slightly in August following a few good data releases in the U.S. For one, the July Consumer Price Index (CPI) report, which measures the overall change in consumer prices of a basket of goods, presented some evidence that supply-side and pandemic-related inflation may be easing. See figure 1

Inflation in the US, as measured by the Consumer Price Index (CPI), jumped to its highest level in four decades at 9.1% on a yearly basis in June from 8.6% in May

Furthermore, there has been some data out of the U.S which indicates that manufacturing is more robust than what some indicators are currently showing. This is welcome news for growth in the U.S economy with the Atlanta Fed’s GDPNow model now pointing to positive growth in Q3 of 2022. See figure 2

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Despite the good data, a few important indicators still suggest that the risk of a U.S recession over the coming months is quite high and that it may be too early to count on a Goldilocks outcome (an economy which has steady growth, preventing a recession, but not too much growth so that inflation rises) for the US economy. Firstly, August Flash PMIs (which is a forward-looking estimate of a country’s manufacturing or service sector) were negative, especially for the services sector. Services PMIs declined significantly not only in the U.S but also in Germany, France, and the UK. U.S survey participants noted that “hikes in interest rates and inflation dampened customer spending as disposable incomes were squeezed”. Secondly the Conference Board’s Leading Economic Indicator (an index used to predict the direction of global economic movements in future months) has dropped for a fifth month in a row in July. This has historically been associated with a U.S recession. Lastly, closer inspection of the July CPI report reveals a less compelling answer for disinflation. Most of the decrease was in fact driven mainly by a decrease in energy prices rather than supply-side, pandemic related or slowing demand effects. See figure 3

It is however uncertain whether energy prices will continue to decline meaningfully over the coming months and so investors may have been slightly optimistic that inflation will soon be under control.

Recessions occur because of two main factors. Either monetary policy becomes too tight (interest rates are too high), or a significant non-policy driven shock to aggregate demand or supply occurs, or some combination of both develops. The combination of the speed of interest rate increases coupled with the fact that real wages have fallen sharply and the fact that the Federal Reserve is determined to see inflation quickly return to target levels, it is clear that the odds of a recession over the coming 12-18 months remain elevated. The Federal Reserve will continue raising rates in the U.S until it sees clear and unequivocal signs that inflation is easing. The Federal Reserve during their July meeting noted that “though some inflation reduction might come through improving global supply chains or drops in the prices of fuel and other commodities, some of the heavy lifting would also have to come by imposing higher borrowing costs on households and businesses”. This shows the Federal Reserve’s determination to bring inflation back within their 2% tolerance level, possibly at the expense of the consumer.

So how will the dollar fair in all of this? The dollar continues to power ahead, reaching fresh multi-year highs in August. The dollar is a reliably countercyclical currency, meaning a currency that appreciates when domestic growth is higher than global growth, and so clearly some of the dollar’s strength has been the result of weakness in risky asset prices. Furthermore, uncertainty within the market due to factors such as the conflict in Ukraine and the housing market in China, all keep the dollar strong due its safe-haven appeal. Despite these factors which support the dollar, we believe that the dollar is due for a correction. The U.S dollar is extremely overbought (meaning it is believed to be trading at a level above its intrinsic value) and is technically extended to a point that has historically been associated with reversals in the broad dollar trend. See figure 4

Valuation models also indicate that the dollar is extremely expensive which underscores that an eventual decline in the dollar may be quite severe. Although valuation is not a great timing tool it does indicate the direction a currency should return to over time and as the dollar has been trading at a premium for longer than historically typical, we can place greater emphasis on its significance.


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