A Rate Cut In The U.S. Is Closer Than Ever, And So Is A Recession

by: The Fortune Teller

New tariffs and/or tweets are causing high volatility.

The smart money continues to signal that an economic slowdown is approaching soon.

The probability of the Fed cutting rates inside 2019 is now more than 80%.

While the leading indices went through a sharp rally during the first months of 2019, the bond markets "insist" on drawing a completely different picture.

Bonds (LQD, AGG, BND, HYG, JNK, AWF, BKLN) suggest that the US economy (SPY, DIA, QQQ, IWM) is heading to a slowdown, if not a recession, that will require the Fed to cut rates even before 2020 starts.

The Cass Freight Index for April posted a 3.2% decline, the fifth consecutive month that the index pointed to an annual decline in activity.

Quoting from the report:

When the December 2018 Cass Shipments Index was negative for the first time in 24 months, we dismissed the decline as reflective of a tough comparison.

When January 2019 was also negative, we again made rationalizations.

Then February was down -2.1% and we said, “While we are still not ready to turn completely negative in our outlook, we do think it is prudent to become more alert to each additional incoming data point on freight flow volume, and are more cautious today than we have been since we began predicting the recovery of the U.S. industrial economy and the rebirth of the U.S. consumer economy in the third quarter of 2016.”

When March was down -1.0%, we warned that we were preparing to "change tack" in our economic outlook.

With April down -3.2%, we see material and growing downside risk to the economic outlook.

Macro data released today in the US also point to a continued slowdown in economic activity, as industrial production in the US fell by 0.5% in April, compared to expectations for no change. On an annualized basis, this is an increase of 0.9%, far from the 5.6% annualized rate recorded last September.

Looking at the US industrial production trends over recent decades, the burning question is: Will the sharp slowdown in recent months end the same way as it did in 2016, or in a recession like most other times?

Another interesting question is how, in spite of all these weak(ening) signs, US GDP growth was 3.2% during the first quarter?

Jeffrey Gundlach, the founder of the DoubleLine Capital Fund, touched upon this conundrum. As you can see below, there's a historical, high, correlation between the Citi Bank Economic Data Index and actual US GDP growth. That is, of course, the case as long as you ignore the past year....

Citi Bank US Economic Data Index and the actual US GDP growth are diverging in an unprecedented manner

It's also worth noting that one of the main reasons for the high rate of growth was a sharp increase in government spending and local authorities. Spending rose 3.9% in Q1/2019 - the sharpest increase in recent years. Such a pace is very unlikely to keep pace in the coming quarters.

What's the result of all of this?

The probability of a reduction in the interest rate over the coming months is rising to >80% today. Judging by history, when the market is pricing such a high level of certainty (for a monetary action) - the Fed usually delivers exactly what the market is expecting for.

Another thing we can learn from the past is that a US recession usually starts shortly after the Fed begins to lower interest rates.

May we also remind you that the probability of a recession over the next 12 months, according to the Fed model, rose to 27.4% in April - its highest level since 2007.

Except for 1998, whenever the model reached such a level - a recession in the US started shortly after.

The Fed has been trying to convince the public in recent months that "this time is different." Is it?

Many investors think that a rate cut, ahead of an actual recession, would be net supportive for risk assets. The logic here is that if the economic data deteriorates to the point where a recession is in play, we will have no choice but to face the inevitable profit declines, regardless of rate cuts.

This seems to be a popular line of thinking right now, evident by risk assets that are rallying in tandem with the safest assets - US Treasuries (IEF, GOVT, SCHR, VGIT, TIP, SHV, SHY, IEF, TLT). Basically, this is bet that the Fed can handle things timely and swiftly.

One can't rule out the possibility that the Fed can maneuver perfectly, allowing the US for a soft landing, in a way that keeps everybody happy. The only "tiny" problem with this dream scenario is that the Fed hasn't really done anything like it (in such perfection) before.

A rate cut is what many wish for, but be careful what you wish for!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.