A US recession is widely expected in the next 12 months. Surveys of financial market participants indicate a 65% probability of a recession, and the National Federation of Independent Business indicates a 100% probability. We see a 50:50 chance of either a mere cooling of the economy or a recession in the next 12 months given that monetary policy tightening has gone on for longer than we had expected.
At 5.25%, the US federal funds rate is well above a neutral level, which increases the risk of a major financial accident resulting from a sharp deterioration in financing conditions. The spill-over effects of such an accident – if large enough – have the potential to generate a self-sustaining economic contraction. For example, the wave of debt set to mature in the US commercial property segment will need to be refinanced amid generally tighter credit conditions.
At the same time, large parts of the real economy remain in good shape, supported by low consumer debt, accelerating real incomes, and a strong investment cycle. This argues for a self-sustaining increase in activity even if GDP growth turns negative in one or two quarters. We expect US growth to slow to 1.7% in 2023 and then further to 0.3% in 2024, with a contraction of activity in the first half of 2024.
Downward yield slope signals recession warning
Ten months ago, the slope of the US yield curve sounded the alarm for the first time that a US recession was imminent. On 6 July 2022, the 2-year US Treasury yield rose above the level of the 10-year US Treasury yield and has remained there since then.
This downward sloping yield curve implies that interest rates will be lower in the more distant future than in the coming quarters. The slope of the yield curve is now as negative as it was back in the 1980s, and the probability of a US recession in the next 12 months, as measured by the slope of the yield curve, has increased to above 90%. Overall, there is growing evidence that a US recession has not yet occurred but rather may be approaching.
Slowdown not yet vicious
There is no doubt that US growth will slow. However, a recession goes well beyond a slowdown in growth or even a contraction in activity. We see the self-reinforcing quality of a slowdown in growth as the critical factor. An economic expansion is characterised by a self-sustaining increase in activity, while a recession is characterised by a self-sustaining contraction, or the shift from a ‘virtuous’ to a ‘vicious’ cycle.
The simple notion of a recession as two consecutive quarters of falling GDP does not capture this self-sustaining dynamic. GDP fell in the first half of 2022, by 1.6% in the first quarter and 0.6% in the second. However, this slowdown in GDP growth in the first half of 2022 reflects the massive increase in the volatility of GDP growth during the post-pandemic boom rather than the onset of a downturn.
Soft landing versus a recession
The current slowdown in growth has little to do with a normalisation after a period of growth volatility. Rather, monetary policy is weighing on growth by making credit more difficult and costly to obtain. A Fed survey shows that the demand for credit is as low and credit standards as tight as they usually are during a recession. Moreover, survey indicators and consumer sentiment are at levels normally associated with recessions.
The strength of the US labour market and solid housing activity suggest that the US economy in general can rely on low debt and a very strong balance sheet – and can thus absorb a slowdown in activity without triggering a further slowdown. Hence, the hurdle for a vicious cycle of US activity that constitutes a genuine recession is currently very high.
The helpful role of nominal growth during recessions
Expanding nominal GDP in times of contracting real activity has the potential to make any eventual recession less severe. First, nominal growth supports tax revenues, reducing the pressure to cut public spending, which could deepen the downturn. Second, there is less pressure to reduce nominal debt in times of positive nominal GDP growth, reducing the risk of a self-sustaining economic contraction.
The history of US recessions suggests that increases in nominal GDP during recessions have generally been the rule rather than the exception. The more severe the real GDP decline was, the greater extent that corporate earnings suffered in every recession. We expect any possible recession at this time to be accompanied by nominal GDP growth given the current momentum of inflation and wage growth, which would make the recession less of a risk for equity markets.
Current and future Fed policy is crucial for both the risk of a US recession in the next 12 months and its duration. Further increases in policy rates will certainly increase the probability of a recession in 2024, and keeping rates high for longer would prolong the downturn. Given these risks, we expect the Fed to start cutting its policy rate by the end of this year, bringing it down to 4% in 2024 and narrowing the gap with nominal GDP growth to avoid a prolonged and deepening recession.