20 Charts in 2020

My team and I just closed out our 2019 travel. After collectively spending about 300 days meeting with our clients across this country, we now turn our attention to 2020. With that in mind, we thought we would aggregate many of our thoughts on 2020 in the 20 charts we have below. These are by no means all-encompassing on our thoughts for next year but do present some ideas and perspective on what we should consider, as far as what the opportunities and risks are for the year ahead.

Enjoy!

“The charts are only relevant when you're top of them!”

~ Noel Gallagher

1. “The yield curve always inverts before a recession” goes the phrase…but what if it doesn’t?

  • Debate continues to rage with the inverted yield curve, or lack thereof, as reason why we are not headed toward a recession. We would agree that a broad-based US economic recession is a low probability event in the next 6-12 months. However, just because the yield curve isn’t inverted (the 10-2 spread) and may not invert doesn’t mean that a recession isn’t possible. Since 1970, when the 10-2 spread flattens on a year-over-year (YOY) basis and is within 10 basis points (bps), a recession follows, on average, 22.7 months and with a median of 20 months later. The spread of the yield curve fell below 10 bps in August of 2019, which according to history, would put the next recession in the middle of 2021. We are getting ever closer to the next recession, but it probably won’t be 2020.
The above bar chart above illustrates the number of months (average and median) to the next recession when the yield curve (the difference between the 10 year and 2-year US Treasury Yield) is at a certain range. When the spread is 0-10 bps, avg = 22.7, median = 20. 10-20 bps, avg 32.6, median 28. 20-40 bps, avg = 40.9, median = 39. 40-60 bps, avg= 47.8 bps, median = 49.5. 60-100 bps, avg = 45.8, median = 43.5 and > 100 bps, avg=67.2 and median 79. The spread of the yield curve fell below 10 bps in August of 2019 which according to history, would put the next recession in the middle of 2021. We are getting ever closer to the next recession, but it probably won’t be 2020.

2. It was never an interest rate problem.

  • While Jay Powell, Chairman of the Federal Reserve and the Federal Open Market Committee (FOMC), cut interest rates three times (75 bps) this year to support the US economy dealing with a trade war, we argue the credit markets wouldn’t have suggested they needed to. According to the Chicago Fed’s national Financial Conditions Credit Sub-Index, credit conditions were, and remain, quite accommodative. In fact, as the Fed was raising rates between 2015 and 2018, credit conditions eased. If we see a softening of the US economy in 2020, credit conditions that were a significant input to the recession in 2008 are unlikely to be the cause.
The above line chart illustrates credit financial conditions in the United States as measured by the Chicago Federal Reserve National Financial Conditions Index. The chart begins in 1971 and ends as of November 30, 2019. While Jay Powell, Chairman of the Federal Reserve and the FOMC cut interest rates 3 times (75 bps) this year to support the US economy dealing with a trade war, we argue the credit markets wouldn’t have suggested they needed to. According to the Chicago Fed’s national Financial Conditions Credit Sub-Index, credit conditions were, and remain quite accommodative. In fact, as the Fed was raising rates between 2015 and 2018 credit conditions eased.

3. Falling shorts may push crude above US$60 into 2020.

  • We have long been observers of speculative interest in the crude markets (non-commercial interest). Along with supply-and-demand fundamentals, speculators have swung the price of crude over the years. Currently, the short position has been dropping to levels not seen since the second quarter of 2018, when the price per barrel of West Texas Intermediate (WTI) crude was above US$65. Long-interest accumulation has lagged the shorts, but we would speculate that a catch-up is on its way. Speculative interest would suggest a return to higher prices for crude.
The above line chart illustrates the relationship between short interest and crude prices (west Texas intermediate in $US). The data begins in October 2014 and ends November 30, 2019. The chart illustrates the strong relationship between the two factors. Along with supply and demand fundamentals, speculators have swung the price of crude over the years. Currently, the short position has been dropping to levels not seen since the second quarter of 2018 when the price per barrel of West Texas Intermediate crude was above US$65. Long interest accumulation has lagged the shorts, but we would speculate that a catch-up is on its way. Speculative interest would suggest a return to higher prices for crude.

4. Higher oil prices may support the Canadian economy.

  • If we see a push higher for WTI, we may see a commensurate push for Western Canada Select (WCS) and support for the Canadian economy. Historically, the Canadian economy has been positively correlated at a lag of three months, with a change in price for crude as measured by WCS. At current prices (US$36.10/bbl at the end of November), Canadian GDP is set to show an improvement YOY into the beginning of 2020. If the price for WCS remains at its current level, we would expect a weakening of the Canadian economy. However, if our theory regarding chart 3 holds true, and WCS averages US$50 next year, the Canadian economy should see a healthier growth profile.
The above line chart illustrates the relationship between Western Canadian Select versus Canada GDP yoy with a 3-month lag. The data begins in 2011 and ends November 30, 2019. The chart illustrates the strong relationship between the two factors. The chart illustrates the strong relationship between the two factors. If we see a push higher for WTI, we may see a commensurate push for WCS and support for the Canadian economy. Historically, the Canadian economy has been positively correlated at a lag of 3 months, with a change in price for crude as measured by Western Canadian Select. At current prices (US$36.10/bbl at the end of November), Canadian GDP is set to show an improvement YOY into the beginning of 2020. If the price for WCS remains at its current level, we would expect a weakening of the Canadian economy.

5. The last word on oil

  • The S&P/TSX Composite Index has been an outlier in 2019 with healthy earnings growth. Historically, earnings for the TSX have correlated with the change in the price of crude YOY. If we see WTI average US$60/bbl in 2020, the TSX should continue to see strong earnings growth, which would set it apart from its international peers. Low relative valuation coupled with stronger earnings growth could drive returns on the S&P/TSX Composite above those of the S&P 500 Index and MSCI EAFE Index in 2020.
The above line chart illustrates the relationship between S&P/TSX earnings per share growth year over year vs. crude prices year over year in $US. The data begins in 1995 and ends November 30, 2019. The chart illustrates the strong relationship between the two factors. The S&P/TSX Composite Index has been an outlier in 2019 with healthy earnings growth. Historically, earnings for the TSX has correlated with the change in the price of crude yoy. If we see WTI average US$60/bbl in 2020 the TSX should continue to see strong earnings growth which would set it apart from its international peers. Low relative valuation coupled with stronger earnings growth could drive returns on the S&P/TSX Composite above those of the S&P 500 Index and MSCI EAFE Index in 2020.

6. Copper prices may be signaling a turn in the Chinese economy.

  • Copper is often referred to as “Dr. Copper” as it tends to be a decent signal for the health of the global economy. Copper has also been a decent indicator of the change in the Chinese economy, at least from an import perspective. Over the past couple of years, followers of the price of copper would have noticed a sharp decline YOY; Chinese import growth YOY followed the decline trend. Should copper prices remain at their current level of US$2.76/lb, it would signal an improving import environment for China into 2020 — or at the very least, a bottoming.
The above line chart illustrates the relationship between Chinese imports vs copper prices year over year.  The data begins in July 2006 and ends November 30, 2019. The chart illustrates the strong relationship between the two factors. Copper is often referred to as “Dr. Copper” as it tends to be a decent signal as to the health of the global economy. Copper has also been a decent indicator to the change in the Chinese economy, at least from an import perspective. Over the past couple of years, followers of the price of copper would have noticed a sharp decline year-over-year, Chinese import growth yoy followed the decline trend. Should copper prices remain at their current level of US$2.76/lb it would signal an improving import environment for China into 2020 – or at the very least, a bottoming.

7. Nothing to see here, the US economy has slowed but no recession yet.

  • The Chicago Fed National Activity Index (CFNAI) is a monthly index designed to gauge the overall health of the United States economy. THE CFNAI is a weighted average of 85 monthly indicators of national economic activity and is closely followed by the US Federal Reserve. Historically, when the CFNAI three-month moving average value moves below -0.70 following a period of economic expansion, there is an increasing likelihood that a recession has begun. Conversely, when the CFNAI-MA3 value moves above -0.70 following a period of economic contraction, there is an increasing likelihood that a recession has ended. The current reading would suggest a weaker economic environment but one that is still far from recession.
The above line chart shows the Chicago Federal Reserve National Activity Index (CFNAI). The data begins in 1967 and ends November 30, 2019. The Chicago Federal Reserve National Activity Index (CFNAI) is a monthly index designed to gauge the overall health of the United States economy. THE CFNAI is an weighted average of 85 monthly indicators of national economic activity and is closely followed by the U.S. Federal Reserve. Historically, when the CFNAI-three month moving average value moves below -0.70 following a period of economic expansion, there is an increasing likelihood that a recession has begun. Conversely, when the CFNAI-MA3 value moves above -0.70 following a period of economic contraction, there is an increasing likelihood that a recession has ended. The current reading would suggest a weaker economic environment but one that is still far from recession.

8. The machines fight back with a turnaround in semiconductor sales.

  • While not “Skynet”,[DH1]  the global semiconductor industry is a uniquely important contributor to the broader global economy, as semi-conductors are the backbone of every electronic device that we take for granted. Semiconductors allowed the miniaturization of electrical components and allowed electronic devices to become affordable to the masses. Without them, we would not have any cell phones, personal computers, big screen TVs, GPS, drones, printers, Wi-Fi, digital photo, Google, etc. As a result, semiconductor sales have a strong correlation to MSCI World Index trailing 12-month earnings. Recent data suggests that semiconductor sales may have bottomed, which could indicate that global earnings growth has troughed.
The above line chart shows semiconductor 3 month moving average year over year percent change sales versus the MSCI World Index trailing 12-month earnings per share. The data begins in 1999 and ends November 30, 2019. The chart illustrates the strong relationship between the two factors. While not “Skynet”, the global semiconductor industry is a uniquely important contributor to the broader global economy as semi-conductors are the backbone of every electronic device that we take for granted. Semiconductors allowed the ‘miniaturization’ of electrical components and allowed electronic devices to become affordable to the masses. Without them, we would not have any cell phones, personal computers, big screen TVs, GPS, drones, printers, Wi-Fi, digital photo, Google, etc… As a result, semiconductor sales have a strong correlation to MSCI World Index trailing 12-month earnings. Recent data suggests that semiconductor sales may have bottomed which could indicate that global earnings growth has troughed.

9. “I don’t want that shiny new big-ticket item…or do I?”

  • Consumers who are confident in their own employment situation are much more likely to buy expensive household items. While manufacturing and capital expenditures by businesses have been weak in the US, the economy has been supported by a strong US consumer. Historically, consumer confidence in big-ticket purchases tends to trail off during the latter stages of an economic cycle. This trend was interrupted recently for a couple of months. We’ll be watching this metric closely in 2020 to gauge whether the late cycle behavior reappears.
The above line chart shows the U.S. unemployment rate versus the University of Michigan Survey of consumer’s belief of whether it is a good time to buy large household goods. The data begins in 1980 and ends November 30, 2019. The chart illustrates the strong relationship between the two factors. Consumers who are confident in their own employment situation are much more likely to buy expensive household items. While manufacturing and capital expenditures by businesses have been weak in the U.S., the economy has been supported by a strong U.S. consumer. Historically, consumer confidence in big ticket purchases tends to trail off during the latter stages of an economic cycle. This trend was interrupted recently for a couple of months. We’ll be watching this metric closely in 2020 to gauge whether the late cycle behavior reappears.

10. Unemployment says recession is further off.

  • Since 1948, the US economy has been in a recession or was entering one when the unemployment rate increased at least half of one percent off its cyclical lows. Regardless of where the cyclical low for unemployment fell, recessions have occurred 11 times following this inflection point. In this current cycle, the unemployment rate reached a low of 3.5% in November 2019. This would imply that an unemployment rate of 4.0% would start along the path to the next recession.
The above line chart shows the U.S. unemployment rate versus recession. The data begins in 1980 and ends November 30, 2019. Since 1948, the U.S. economy has been in a recession or was entering one when the unemployment rate increased at least ½ of 1 percent off its cyclical lows. Regardless of where the cyclical low for unemployment fell, recessions have occurred 11 times following this inflection point. In this current cycle, the unemployment rate reached a low of 3.5% in November 2019. This would imply that an unemployment rate of 4.0% would start the along the path to the next recession.

11. “But what about all that money the Fed printed?” (yeah, we love busting that myth)

  • A question that we often receive is whether the US term structure is reliable as an indicator (coincident or otherwise) for economic activity given the unprecedented amount of US central bank intervention since the Great Financial Crisis. In other words, are yields really a reflection of the economy or have they been “manipulated with all the printing of money?” The size of the Federal Reserve’s balance sheet has grown four times since the financial crisis via multiple quantitative easing programs. Be that as it may, the graph below highlights that the health of US manufacturing and the US 10 Year Treasury rates have trended in line with each other since the Great Financial Crisis, regardless of quantitative easing.
The above line chart shows the U.S. 10-year yield versus ISM Manufacturing PMI. The data begins in 2009 and ends November 30, 2019. A question that is often asked is whether the U.S. term structure is as reliable of an indicator (coincident or otherwise) for economic activity given the unprecedented amount of U.S. central bank intervention since the Financial Crisis. In other words, are yields really a reflection of the economy or have they been “manipulated with all the printing of money?” The size of the Federal Reserve’s balance sheet has grown four times since the Financial Crisis via multiple quantitative easing programs. Be that as it may, the graph below highlights that the health of U.S. manufacturing and the U.S. 10 Year treasury rates have trended in line with each other since the Great Financial Crisis regardless of quantitative easing.

12. Sweden exports more than just meatballs and frustrating IKEA furniture…and it doesn’t look encouraging for Europe.

  • The Swedish economy exports cars, refined petroleum, vehicle parts, medicine, and paper and wood products. Sweden’s largest trading partners are European Union nations, which account for eight of their top 10 trading partners. Those countries account for nearly 85% of Sweden’s top 10 exports. After stabilization of Euro Area PMIs over the past couple of months, the Swedish data suggests that if this historical relationship continues, Euro Area PMI is unlikely to continue its recent improvement.
The above line chart shows the differences between Sweden’s orders and inventories within their manufacturing PMI and the Euro Area PMI. Euro Area PMI lags the former by five months. The data begins in 2011 and ends November 30, 2019. The Swedish economy exports cars, refined petroleum, vehicle parts, medicine, and paper and wood products. Sweden’s largest trading partners are European Union nations which account for eight of their top 10 trading partners. Those countries account for nearly 85% of Sweden’s top 10 exports. After stabilization of Euro Area PMIs over the past couple of months, the Swedish data suggests that if this historical relationship continues Euro Area PMI is unlikely to continue its recent improvement. A question that is often asked is whether the U.S. term structure is as reliable of an indicator (coincident or otherwise) for economic activity given the unprecedented amount of U.S. central bank intervention since the Financial Crisis. In other words, are yields really a reflection of the economy or have they been “manipulated with all the printing of money?” The size of the Federal Reserve’s balance sheet has grown four times since the Financial Crisis via multiple quantitative easing programs. Be that as it may, the graph below highlights that the health of U.S. manufacturing and the U.S. 10 Year treasury rates have trended in line with each other since the Great Financial Crisis regardless of quantitative easing.

13. It’s still early but the US Manufacturing economy may be bottoming.

  • One could argue that the US manufacturing economy has been experiencing a recession amid rising trade headwinds and slowing global economies. However, there appears to be light at the end of the tunnel. Historically, the difference between the ISM New Orders and Inventories indices had led the broader ISM Manufacturing PMI by six months. The spread between new orders and inventories has been trending higher in three of the last four months. While not enough to call a trend, the inflection point is worth noting. Recent data suggests that as we enter the summer of 2020, manufacturing should finally dig itself out of its recessionary hole.
The above line chart shows the differences between ISM manufacturing versus the ISM inventory new order spread. The Inventory new order spread leads ISM Manufacturing by six months. The data begins in 2000 and ends November 30, 2019. The chart illustrates the strong relationship between the two factors. One could argue that the U.S. manufacturing economy has been experiencing a recession amid rising trade headwinds and slowing global economies. However, there appears to be light at the end of the tunnel. Historically, the difference between the ISM New Orders and Inventories indices had led the broader ISM Manufacturing PMI by 6 months. The spread between new orders and inventories has been trending higher in 3 of the last 4 months. While not enough to call a trend, the inflection point is worth noting. Recent data suggests that as we enter the summer of 2020 that manufacturing should finally dig itself out of its recessionary hole.

14. History would suggest investors can profit from the dip — but pay attention to recession risk!

  • The S&P 500 compound annual growth rate has been 7.6%, excluding dividends, since 1950. However, the ride is rarely smooth. On average the US equity market suffers two 5% pullbacks in any calendar year or one 10% correction every couple of years. Often, these market pullbacks or corrections are opportunities to be taken advantage of. The chart below illustrates that investors can capitalize on volatility by adding to equities during pullbacks or corrections that are function of negative sentiment. But beware, corrections in recessionary conditions lead to further downside. With less evidence of a pending recession, we would embrace a correction should one occur. Oh, and the last correction was Q4 2018.
The table above shows the return for the S&P 500 on a one year forward basis after sell offs of 5,10,15 and 20 percent. Within each sell off, it illustrates returns when the sell occurred during a recession and excluding recession. If markets are down 5% from their calendar year peak, one year forward returns on average are 9%, during recession -9%, excluding recession 15%. If markets are down 10% from their calendar year peak, one year forward returns on average are 7%, during recession -6%, excluding recession 20%. If markets are down 15% from their calendar year peak, one year forward returns on average are 15%, during recession 11%, excluding recession 23%. If markets are down 20% from their calendar year peak, one year forward returns on average are 18%, during recession 20%, excluding recession 15%. The S&P 500 compound annual growth rate is 7.6% excluding dividends since 1950. However, the ride is rarely smooth. On average the US equity market suffers two 5% pullbacks in any calendar year or one 10% correction every couple of years. Often, these market pullbacks or corrections are opportunities to be taken advantage of. The chart below illustrates that investors can capitalize on volatility by adding to equities during pullbacks or corrections that are function of negative sentiment. But beware, corrections in recessionary conditions lead to further downside. With less evidence of a pending recession, we would embrace a correction should one occur. Oh, and the last correction was Q4 2018.

15. South Korea, the Sweden of the world

  • South Korean exports are a closely watched bellwether by our team for world trade, as it’s the world’s fifth largest exporter but also exports a wide variety of goods (most notably electrical machinery) that find themselves into many of the products that we use. South Korea’s top export destinations are China, US, Vietnam, Hong Kong, and Japan. Many of South Korea’s exports are used along the supply chain in final products manufacturing in these countries. Globalization over the past two decades has resulted in South Korean exports tracking MSCI EAFE earnings closely (in addition to the S&P 500 Index). We will be watching South Korean exports closely to see whether we are nearing an infliction point leading to a potential recovery in MSCI EAFE earnings.
The above line chart shows south Korean exports year over year vs. MSCI EAFE trailing earnings. The data begins in 1996 and ends November 30, 2019. The chart illustrates the strong coincidental relationship between the two factors. South Korean exports are a closely watched bellwether by our team for world trade as it’s the world’s fifth largest exporter but also exports a wide variety of goods (most notably electrical machinery) that find themselves into many of the products that we use. South Korea’s top export destination are China, U.S., Vietnam, Hong Kong and Japan. Many of South Korea’s exports are used along the supply chain in final products manufacturing in these countries. Globalization over the past two decades has resulted in South Korean exports tracking MSCI EAFE earnings closely (in addition to the S&P 500 Index).

16. Are investors changing their behavior?

  • Mutual fund investors are a fickle bunch. They tend to follow the trend of the market and ironically buy high and sell low. But is a change in the wind taking hold? Typically, when the S&P 500 Index is up YOY, the 12-month moving average for equity and balanced net flows follows strongly. However, as investors were selling into the correction last December, as they typically do, they have not embraced the recovery in 2019 but rather continue to sell out of equity and balanced funds (including ETFs). Will a very positive statement to close out the calendar year shift sentiment? Or is there more of a demographic shift at play?
The above line chart shows equity and balanced Mutual Funds and ETFs flows in millions versus the 1 year rolling returns for the S&P 500. The data begins in 1998 and ends November 30, 2019. Mutual fund investors are a fickle bunch. They tend to follow the trend of the market and ironically buy high and sell low. But is a change in the wind taking hold? Typically, when the S&P 500 Index is up yoy, the 12-month moving average for equity and balanced net flows follows strongly. However, as investors were selling last December into the correction, as they typically do, they have not embraced the recovery in 2019 but rather continue to sell out of equity and balanced funds (including ETFs).

17. And by the way, where did all the equity investors go?

  • Excluding gains, all of the inflows into equity and balanced mutual funds in the United States since 1998 have effectively been redeemed. Some of the proceeds have flowed into equity ETFs but more recently, since March 2018 to be specific, equity and balanced funds including ETFs have been in net redemptions. Bond funds and ETFs have been the beneficiary to the flows. Perhaps this is as a result of an aging investor population planning for retirement. However, at the same time, investor appetite for bonds has made it easier for corporations to issue new debt and do what with some of it? Yep, buy back the equity that the retail investors apparently don’t want. It is a virtuous cycle after all.
The above line chart shows cumulative equity and balanced mutual fund (MF) sales, equity and balanced MF and ETF flows, cumulative fixed income flow and cumulative fixed income MF and ETF flows. The data begins in 1998 and ends November 30, 2019. Excluding gains, all of the inflows into equity and balanced mutual funds in the United States since 1998 have effectively been redeemed. Some of the proceeds have flowed into equity ETFs but more recently, since March 2018 to be specific, equity and balanced funds including ETFs have been in net redemptions. Bond funds and ETFs have been the beneficiary to the flows. Perhaps this is as a result of an aging investor population planning for retirement.

18. On the one hand, the market isn’t as expensive as it was in March of 2000, but on the other hand, it is…

  • We tend to look at the market as one single P/E ratio. In that regard, the market isn’t as expensive as it was at the top in March 2000. But is that the best way to look at things? When we apply the constituents of the S&P 500 Index to what we call a “value curve”, it tells a different story. While the most expensive 245 stocks on the S&P 500 Index today are cheaper than the most expensive 245 stocks of March 2000 (as measured by the trailing 12-month P/E ratio), the cheapest 255 stocks today are more expensive than their 2000 equivalents. On average, this market is cheaper than in 2000, but averages don’t often tell the whole story.
The above line chart shows the ranges of values for the S&P 500 Index constituents trailing 12-month P/E ratio. End date as of Market High of each year compared to November 2019. We tend to look at the market as one single P/E ratio. In that regard, the market isn’t as expensive as it was at the top in March, 2000. But is that the best way to look at things? When we apply the constituents of the S&P 500 Index to what we call a “value curve” it tells a different story. While the most expensive 245 stocks on the S&P 500 Index today are cheaper than the most expensive 245 stocks of March 2000 (as measured by the trailing 12 month P/E ratio), the cheapest 255 stocks today are more expensive than their 2000 equivalents. On average, this market is cheaper than in 2000, but averages don’t often tell the whole story.

19. The S&P/TSX Composite Index has decoupled from the rest of the world.

  • Market correlations ebb and flow. Historically, the Canadian equity market has consistently held a higher correlation to Asia than to other developed markets around the world. That has changed over the past three years, where Canadian equities have decoupled not only from the US, Europe, and Japan but also from Asia. Canada appears to offer greater diversification relative to other equity markets. Given attractive valuation, prospects for improved earnings growth, and greater diversification benefits, perhaps it is time to once again refocus our attention to the Great White North.
The above line chart shows the 3 year rolling correlations between S&P / TSX and S&P 500, S&P / TSX EuroStoxx 600, S&P / TSX and Topix and S&P / TSX and MSCI Asia ex – Japan Indices. Market correlations ebb and flow. Historically, the Canadian equity market has held a higher correlation to Asia consistently than to other developed markets around the world. That has changed over the past three years where Canadian equities have decoupled not only from the US, Europe and Japan but also from Asia. Canada appears to offer greater diversification relative to other equity markets. Given attractive valuation, prospects for improved earnings growth and greater diversification benefits, perhaps it is time to once again refocus our attention to the Great White North.

20. It’s all relative!

  • “What will the Fed do the next time there is a recession?” is a common question we receive given the low level of interest rates. The presumption is that the Fed “needed” to get the Federal Funds Rate to “normal levels” in order to have room to cut in the next recession. “Normal levels” was considered by many to be north of 4%. On average, when the FOMC cuts, it cuts by 500 bps. Therefore, if rates weren’t at least that high, what could the Fed possibly do next time? We suggest it isn’t the absolute level of Fed cuts but relative [DH1] that matters. During a recession, the Fed cuts the Federal Funds Rate by a relative 68% on average. Outside of a recession, when the Fed eases, it eases by a relative 25% on average. Take this most recent easing. Going from 2.50% to 1.75% is a cut of rates by approximately 30% — or near the average mid-cycle. Should we see a recession before the Fed has an opportunity to raise, it still has plenty of room when looked at this way. Assuming a relative reduction in rates by 70%, the Federal Funds Rate during the next recession will reach 0.25% to 0.50%. Negative yields are a possibility in the United States, but it wouldn’t be because the Fed needs to cut by 500 bps.
The above chart shows the amount of each Fed Rate cut in percentage terms during easing cycle within a recession and not. “What will the Fed do the next time there is a recession?” Is a common question we receive given the low level of interest rates. The presumption is that the Fed “needed” to get the Federal Funds Rate to “normal levels” in order to have room to cut in the next recession. “Normal levels” was by many considered to be north of 4%. On average, when the FOMC cuts, it cuts by 500 bps. Therefore, if rates weren’t at least that high, what could the Fed possibly do next time? We suggest it isn’t the absolute level of Fed cuts but relative that matters. During a recession the Fed cuts the Federal Funds Rate by a relative 68% on average. Outside of a recession, when the Fed eases, it eases by a relative 25% on average. Take this most recent easing. Going from 2.50% to 1.75% is a cut of rates by approximately 30% - or near the average mid-cycle. Should we see a recession before the Fed has an opportunity to raise it still has plenty of room when looked at this way. Assuming a relative reduction in rates by 70%, the Federal Funds Rate during the next recession will reach 0.25% to 0.50%. Negative yields are a possibility in the United States but it wouldn’t be because the Fed needs to cut by 500 bps.

A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.

Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.

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Philip Petursson

Philip Petursson, 

Chief Investment Strategist, Manulife Investment Management

Manulife Investment Management

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Kevin Headland

Kevin Headland, 

Senior Investment Strategist, Manulife Investment Management

Manulife Investment Management

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Macan Nia

Macan Nia, 

Senior Investment Strategist, Manulife Investment Management

Manulife Investment Management

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