Markets signalling slowdown in US economy

The latest economic indicators show that the United States economy is slowing. How much the economy actually slows is something that markets will try to anticipate.

In the second quarter, the US economy grew at an annualised rate of 2.5 percent, well below the 5.6 percent rate of the first quarter. In the opinion of most economists, this is confirmation that the economy has begun to slow.

The question in most economists' minds is exactly how much the economy will slow. Will the growth rate slow to its long-term trend, below the trend, or below zero? After Friday's weaker-than-expected employment report from the Labor Department showing 113,000 job gains in July and a higher unemployment rate of 4.8 percent and with the Federal Reserve due to make a decision on monetary policy tomorrow, this question is especially pertinent.

The latest surveys by the Institute for Supply Management in July also show that the economy has slowed but is still growing. The manufacturing purchasing managers' index actually rose slightly to 54.7 in July from 53.8 in June but is below the levels of most of 2005 and early 2006. The non-manufacturing business activity index fell to 54.8 from 57.0 in June and is well below levels of over 60 that it had maintained for most of 2005 and early 2006. However, both indices have remained above 50, indicating that activity continues to grow.

While the views of purchasing managers provide a very useful picture of the state of the economy, the views of investors are also important. The following chart provides some clues to the views of stock and bond market investors.


The chart shows how year-on-year real GDP growth, the spread between 10-year Treasury yields and the federal funds rate and the year-on-year change in the Standard & Poor's 500 Index have varied over a period of slightly over half a century. Several observations and conclusions can be made from the chart.

First of all, the right end of the chart shows that while second quarter real GDP growth was well down from the first quarter on a quarter-on-quarter basis, on a year-on-year basis, real GDP growth was only flat and was actually quite decent at 3.5 percent.

Secondly, both the spread between 10-year Treasury yields and the federal funds rate and the year-on-year change in the S&P 500 have been declining. The chart shows that in previous cycles, such a decline often precedes a slowdown in real GDP growth. So while year-on-year GDP growth is not showing a significant downtrend at the moment, it probably soon will.

Thirdly, the graphs for the spread and the S&P 500 are not yet at low-enough levels to indicate an impending recession. But this is provided they do not deteriorate much further.

And that brings us to the fourth point. The 10-year Treasury note is currently yielding around 4.9 percent. That is 35 basis points below the current target federal funds rate. Should the Federal Reserve decide to raise the target rate another 25 basis points tomorrow, that would probably bring the spread even further into negative territory.

Furthermore, stock markets are likely to react negatively to a rate hike as well. And while the S&P 500 may be sitting in positive territory on a year-on-year basis currently, the above chart shows that in major economic downturns, it usually bottoms after the spread. In other words, should the Federal Reserve tighten further, the stock market might have quite some way down to go yet.

And if the above chart is anything to go by, so might the economy.