Are the signals that usually precede cyclical downturns present today?

The purpose of this post is to understand the conditions that led up to the two most recent major cyclical economic and financial market tops in order to determine whether or not they are present today.  However, what the following does not seek to do is provide a short-term macro market outlook.  Nor does it attempt to predict the trajectory of the ongoing recovery from the Global Recession.  The goal is to simply determine whether or not today's macro environment is similar to that of the prior two cyclical turning points.

Most importantly, this analysis is not a substitute for sound risk management.

With all that said, what were the warnings signs heading into the recessions that began in March 2001 & December 2007?

1.)  The treasury yield curve inverted before widening for all the wrong reasons.

• Between May & July of 1998, a treasury yield curve inversion occurred for the first time in that cycle.  It would do so again from February 2000 to January 2001.
• Starting in February 2006 until June 2007, the yield spent the majority of its time below a zero reading.
• In each case, when the measure finally did break above zero it initially did so because short-term treasury rates were falling faster than long-term government bond yields.  Ideally, in a healthy economic expansion one would prefer a widening yield curve due to rising long-rates outperforming their short-term counterparts.
• The yield curve inversion would have alerted investors/traders that a potential downturn may be on the way in the months to come while the bearish widening certainly should have done so.

2.)  Long-term treasury yields were in an established downtrend.

• Clearly long-term treasury yields have been in a secular downtrend since 1981.  However, on a cyclical basis yields rise when market participants pricing in improving expected aggregate nominal income/spending growth (inflation and/or real growth). Therefore, it should come as no surprise that declining yields tend to precede recessions.
• In January 2000 the 10-year treasury yield topped before trending lower for over a year in the lead up to the 2001 downturn.
• June 2007 marked the start of the reversal lower in the 10-year yield, a full six months before the December 2017 downturn.  In the process it broke the June 2005 low in November 2007 which provided even greater reason to be concerned. 

3.)  High yield credit spreads widened continuously before blowing out.

• In October 1997 high yield credit spreads bottomed.  By the summer of 1998, they were clearly trending higher.  This widening was reconfirmed two summers later in June 2000 when spreads broke above 52 week highs.  Within a year, the economy found itself in an official recession.
• June 2007 saw high yield credit spreads hit a cyclical low, but by July 2007 they were in a confirmed uptrend.  Price action in the beginning of November 2007 reconfirmed this widening as 52 week highs were definitely surpassed.
• Junk bond selling relative to safer securities offered a clear indication that market participants were becoming increasingly risk adverse in the far end of the risk spectrum.  Those that paid attention would have at least entertained the possibility that market turmoil was around the corner. 

4.)  The monthly moving averages of the major US equity indices exhibited a bearish crossover.

• For the first time in a half decade, by January 2001 the S&P 500, Dow, and NASDAQ had all experienced a bearish monthly moving average crossover as the 10-month moved below the 20-month moving average.  The NYSE Composite would also do so as well in Q1 2001.  US equity indices went on to fall by 35%-55%.
• This bearish crossover would not occur again in all the major US indices until March/April 2008.  After that point, US equities would go on to decline by 45%-55%.
• It goes without saying that being long US equity indices after they experience such a bearish crossover can expose investors & traders to a larger probability of big losses.  

5.)  Nominal GDP growth was decelerating persistently.

• Most damningly for US policymakers, US nominal aggregate income/spending growth peaked in Q2 2000 and was then allowed to slow for four straight quarters by the time the 2001 recession began.
• In the pre-GFC cycle, despite NGDP hitting its highest growth rate in Q2 2004 (7.13%), the pace of nominal growth did remain steady above 6% up until Q2 2006.  Alarmingly, nominal GDP would then go on to slow for about six quarters before the start of the recession.
• As policymakers failed to respond appropriately, the continuous deceleration in NGDP would have hinted to market participants that not all was well in the underlying economy.

Are the above ominous conditions present today? 

It is certainly possible that the red flags listed above may raise a false (or too early of an) alarm should they take place on an isolated basis.  However, when they occur simultaneously as they had leading up to the previous two recessions, market participants and especially policymakers would do well to heed their warnings.  With that in mind, are any of these symptoms happening today?  Put simply, no they are not. 

1.)  The yield curve has yet to invert despite flattening by roughly 2% since December 2013.

• Although the yield curve peaked in December 2013, it has yet to invert in the post-Great Recession recovery era.
• Moreover, short-term rates are very much in an uptrend as the Fed has become less accommodative.

2.)  Long-term treasury yields are trending higher or at the very least in a period of sideways consolidation.

• Since the 2011 Eurozone Crisis, 10-year yields have ranged between 3%-1.37%.
• As expected, during the Eurozone bust up as well the 2016 China scare yields fell to cyclical lows.
• However, the latter period of risk aversion eventually gave way to renewed optimism that saw the 10-year yield move toward the middle of the range.  As of late, the yield on the long bond has risen above the March 2017 high. 
• This price action is not typically observed ahead of major cyclical corrections, but a break below the September 2017 low would change this tune.

3.)  High yield credit spreads are narrowing toward cyclical lows.

• Although high yield spreads certainly signaled that caution was warranted between the summer/fall of 2014 & February 2016, these trends quickly reversed after policymakers reacted to the powerful risk-off move of that period.
• Since that market turbulence, spreads have narrowed to where they are now in the process of testing cyclical lows.  It's unlikely that a cyclical turn will take place without spreads first moving above levels witnessed between March & November 2017.

4.)  A bullish monthly moving average crossover is currently in place.

• The 2016 China scare did usher in a bearish monthly moving average crossover in the major US equity indices for the first time since the end of the Global Financial Crisis.
• However, this soon reversed as global risk-off transformed into a renewed sense of risk-seeking.  As a result, a bullish crossover has been in place since the summer of 2016.
• At least for now, this bullish configuration seems to be confirming the strength in the broader markets and economy. 

5.)  Nominal GDP growth has been accelerating albeit off of recent cyclical lows.

• Although NGDP growth did slow markedly between Q3 2014 until Q2 2016, a nominal income growth rebound has been underway ever since.
• Unlike 2000/2001 & 2007, global policymakers (Fed, ECB, BOJ, PBOC) did not allow the global growth slowdown and financial market turmoil to turn into an all-out panic induced global recession.
• With that said, given that the 20%+ rise in the dollar occurred during a period that saw rapidly declining treasury yields, widening high yield credit spreads, and down-trending equity indices, policymakers came perilously close to repeating past cyclical errors.
• As of now, nominal GDP growth is moving in the right direction which is inconsistent with prior cyclical turns. 

Concluding remarks:

Should any of the current trends reverse where a yield curve inversion gives way to short-term treasury rates falling faster than long-term yields in a backdrop characterized by widening credit spreads, topping equity markets, and most importantly decelerating nominal domestic aggregate demand, it would certainly be prudent for market participants and policymakers to react* accordingly.  Crucially, this confluence of symptoms was well established by the time the previous two recessions had begun, yet they are simply not present today even as the post-Global Financial Crisis recovery enters its ninth year.  Seeing as they tend to occur together well in advance of important cyclical downturns, market participants should have plenty of time to respond when the time comes.  Nonetheless, we are just not there yet.

*The philosophy of this blog is that planning and reacting are a better strategy than predicting/forecasting.  The future is unknowable with any degree of precision.  However, it is possible to monitor a set of measures that provide useful insights into the current risk appetite of market participants as well as the health of the financial economy.  When the five gauges jointly cast a loud siren, it will be time to react defensively.