The US Recession Is Delayed, Not Derailed
As economic data weakens, what’s the future for the US bond market?
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Most analysts have given up the notion of the US even coming close to a recession this year. This is in stark contrast to last year when each and every single analyst predicted a recession following the Fed’s embarking on one of the fastest rate-rising campaigns in history when they took the US interest rates up 550 bps in one go! Of course, a recession was almost a certainty to the naive eye. We had a financial system wobble in March '23 when nearly all US regional banks started falling. But this was avoided as the Fed opened the floodgates and injected the system via the backdoor with trillions in liquidity even though on the face of it, they were still "doing quantitative tightening" to keep the optics in check.
On top of this, one needs to consider the massive US fiscal spend. Biden injected the system with trillions again, and this is still filtering through, which is why we saw such a surge in employment and demand, causing supply chains to be choked. Given China's debt burden, their exporting goods deflation has helped ease the Fed's nightmare. Without the slowdown in that part of the world, the US would never have seen such a quick move lower in inflation. Today, the CPI has moved down to 3.5% y/y, but it remains sticky at these levels, given the strength of services offset by the weakness of manufacturing. Still, we are far from the Fed's 2% target.
All this excess liquidity just masked the underlying weakness rather than delayed it. 15 months later, we see US economic data slow down rapidly. Every indicator, including housing starts, construction of multi-family units, ISM, and jobless claims all show a marked slowdown. This is causing the US bonds to rally, despite the Congressional Budget Office releasing a higher estimate of the deficit to the order of $450 bln. More debt to be issued at a time when there are fewer buyers. It is still the lesser evil and a source of safe haven at a time when the entire world is rolling over.
There is another issue. Most banks have been sitting on marked to market losses since last year when the Fed aggressively raised rates and threw off the bank’s assets vs liabilities matching. They are all waiting for the Fed to cut so that they can warehouse this risk. But this is taking much more time. The Fed may have underwritten them with their BTFP program. But it is different in Japan. According to the U.S. Treasury Department, Japanese investors held $1.18 trillion of U.S. government bonds as of March, the largest slice among foreign holders. We heard the latest from Norinchukin Bank, which has now decided to sell $63 billion of its holdings in US and EU government bonds during the year ending March 2025, given the negative carry. It is now turning its paper losses into realized losses. This is a game-changer. If we go back to 2008, all the big banks were waiting to see which would be the first to blink. As of May, Norinchukin put its final loss at more than 500 billion yen, which is now expected to reach the 1.5 trillion yen level.
One wonders how much Yellen can keep the back of the US bond market "supported" as 10-year yields are trading down to 4.22% from highs of 4.75%. Given current inflation rates of close to 3.5% and real GDP growth of 1.5%, 5% seems fair value for now.
Equities are not the economy, but if one looks at every single segment of the economy from the average US consumer and its outlook and sentiment, the US is already at the start of a recession. By the time the Fed realizes, it will be too late as always. Being an election year, they will try to pump even more liquidity and cut rates. Will it be enough?
