On the Cusp of Recession or Recovery?

Where the first six months of the year was driven by a dramatic shift in the global market picture following the Fed's pivot, what followed was a summer and early fall that can be characterized as noisy.  Global investors have had to deal with persistent US-China trade tensions amid a global economic slowdown, China's attempted rebalancing away from a credit financed investment led growth model, Brexit, repo market issues, etc.  Yet, the market backdrop from a price action perspective has not changed very much over the last four months.

The US 10-year yield remains in a downtrend with only initial signs of a potential bottoming process.

• By the end of Q4 2018, market participants had already begun to anticipate that the Fed would be forced to react to what has turned out to be a deceleration in domestic and global economic growth for much of 2019.  Asset managers did this by sending yields on the safest sovereign securities lower first before flooding into the rest of the global credit markets as Powell pivoted away from an overly hawkish stance.  This saw the 10-year yield cut in half in less than a year.
• Although long-term treasury yields are still in a downtrend, the long end of the curve has been showing signs of bottoming right near multi-year support levels.  
• If the ongoing trend toward global monetary easing proves to be effective particularly coming out of the Fed, this should manifest itself in improving nominal growth and inflation expectations in the months ahead.  A consequence of this would be long rates that remain well supported at current levels much like they were after prior global growth slowdowns in 2011/2012 & 2015/2016.
• However, should this recent backup in long rates prove temporary, markets may signal that the global growth deceleration is not over yet.  Either way, market participants should learn something regardless of whether or not US 10-year yields reverse from here.
• Importantly, the Fed's attempt to "normalize" by hiking rates particularly throughout 2018 paved the way for lower rates today.  This should serve as a reminder that the most effective way to push interest rates higher is by creating conditions that enable the pace of domestic and global nominal GDP to accelerate.  The Fed was effectively stepping on the breaks while wondering why inflation refused to remain near their 2% target.  

US high yield credit spreads have been contained and are not showing too much sign of stress yet.

• Whether one looks at spreads or the high yield bond ETF HYG, it's clear that the Fed's turn toward a more dovish stance arrested the stress in the credit markets that was present in Q4 2018.  The high yield bond ETF HYG had put in a low by the end of December 2018, rebounded powerfully, and has since gone on to consolidate since May.  A break above the summer highs should correspond with tighter spreads both of which would support a more bullish stance toward risk assets.
• Investors have three clearly defined price levels to manage risk in the form of the three 2019 summer correction lows.  A break below all three would serve as a warning.

US equity indices are still range bound and testing a breakout above all-time highs.

• Big picture, US indices have been range bound for nearly two years.  Despite the pessimistic sentiment readings and flood into low or even negative yielding credits, US equities appear to be consolidating right above the 2018 highs.  Meanwhile the short-term VIX ETF VIXY is breaking key support levels.  This is the same setup that occurred in 2012 and 2016 right before US indices ended their multi-year trading range to the upside.
• A bull move in US equities will support the notion that domestic growth is on the verge of bottoming out at some point in late 2019/2020.  Much like the running theme throughout this post, this is to be determined as US equity markets still have some work to do even if green shoots are appearing in the price action.  

The uptrend in the US dollar is intact, but momentum has been decelerating into long-term resistance.    

• Given the dollar's role in the global financial markets, its uptrend that began in Q1 2018 has weighed heavily on international equities.  Whether the greenback's appreciation is a cause or an effect of the global slowdown, it has served as a useful proxy for risk appetite.  
• Thus for the bullish thesis to strengthen, it will likely require that the USD's slowing momentum turn into a trend reversal and eventual downtrend.
• Interestingly enough, as treasury yields hit an important support zone, the USD has reached multi-year resistance levels.  This strongly indicates that rising yields and a weaker dollar should not be ruled out going forward.  However, it still remains to be seen as it is too early to call a definitive end to these two major trends.
• Ironically, international asset managers who have crowded into long duration US treasuries and investment grade fixed income in search of a safe yield have exposed themselves to interest and FX.  These two risks are elevated today following a period where long rates have collapsed while the dollar has trended higher for over a year.  

Foreign equities have kept on building a base after 2018's declines.  

• As the dollar's momentum has waned, 2018's decline in foreign equities has morphed into a sideways consolidation for much of this year.
• While US duration has benefit from the dollar's appreciation as a result of foreign demand, this has come at the expense of EM, Chinese, and international equities.  Therefore, any potential future period of dollar weakness should see EM equities trend higher with US yields.  On the other hand, a further decline in US long rates in the months and years to come that coincides with a more pronounced global growth deceleration will not bode well for foreign stocks.  
• With US equity indices attempting to breakout to the upside, foreign equity participation would confirm the sustainability of such a bullish outcome much like they did in 2012 & 2016.    

Oil and commodities continue to exhibit price action that is consistent with secular bear markets.  

• Commodities have been in a secular bear market that began somewhere between 2008 & 2011.  Although commodities have rebounded whenever risk appetite has resumed, each successive major high has been lower than the prior one made.  Moreover, each growth scare since the GFC has produced drastic declines in commodities.
• This combination of falling yields and commodities has signaled that market participants anticipate that inflation will remain muted.  Should this remain in place, the Fed has little reason not to continue easing particularly considering this drop in inflation expectations has occurred during a nearly 10-year period where the Fed has consistently misses their 2% inflation target.  Had the Fed carried over their hawkish stance into 2019, they would have jeopardized the credibility of their inflation target if they haven't already.  

What does this market composition mean for the US & global economic outlook?

• Where 2016 through the first half of 2018 saw a resurgence in US nominal GDP growth, the decelerated from that pace is clearly evident in the macro data.  The rate of annual nominal GDP relative to the FFR or 3-month bill rate has been falling with effective demand.
• In early 2016, the Fed's reaction and the resumption of global credit easing effectively stopped the China induced global growth scare and extreme risk aversion from turning into a US recession.  The hope is that the monetary measures taken so far in 2019 will have similar results.  As financial markets are forward looking, bullish price action in US & foreign equities, tightening credit spreads, and a bottoming in long term yields would suggest that future economic data may come in better than expected.
• With that said, if US nominal GDP growth fails to stop slowing in the months ahead, then this would hint that any trend in risk assets may not be durable.

Overall, the current intermarket relationships discussed in this post resemble 2012 & 2016.  The global monetary stance has eased and financial conditions have loosened with US equities near highs and credit spreads tight.  The dollar has appreciated while treasury yields have essentially collapsed.  Although the trends in the USD and US long rates are still in place, they are both showing signs of exhaustion.  A reversal in each could easily undermine the current pessimism among global asset managers who have crowded into US fixed income and negative yielding debt around the world.  In hindsight, the pessimism in 2012 & 2016 proved to be the wrong stance.  Will 2019 resolve itself in a similar bullish fashion?  Watch the summer lows in risk assets.  Whether they hold or not, investors will learn whether recession or recovery is more likely on the horizon.