The U.S. economy shows signs of extending its nine-year expansion with the help of tax cuts and strong business and consumer confidence.
Both the longevity of the expansion and the apparent limited slack in the labour and product markets suggest the current pace of growth is probably not sustainable in the medium term.
The current cyclical expansion is 110 months old and will be the longest on record if the economy is still growing in July 2019.
While longevity alone is not a good predictor of cyclical turning points, with most financial and economic indicators close to multi-decade highs, the balance of risks is shifting.
“What matters primarily ... is not the passage of calendar time but what happens over time in and to the economy in motion. It is historical and psychological time, filled with events and processes, perceptions and actions.
“There is a simple corollary: knowledge of the current phase of the business cycle and its age can help but must not be used in isolation,” Victor Zarnowitz, a leading U.S. expert on business cycles, wrote in 1992.
“The variability in length of business expansions and contractions is sufficiently large for the timing of cyclical turning points to be very difficult to forecast.
“The age of a phase alone is not of much help in predicting its end: what matters more is the dynamics of the evolving business situation. (”Business cycles: theory, history, indicators and forecasting,” Zarnowitz, 1992)
Zarnowitz went on to observe: “The largest errors in forecasts ... are made in the vicinity of business cycle and growth cycle turning points, particularly peaks.
“Many forecasts are overly influenced by the most recent events or developments; they rely on the persistence of local trends and are insufficiently cyclical in the sense they miss recessions and recoveries.”
Yield curve inversion
Fears about a future slowdown in the U.S. economy have grown as the U.S. Treasury curve has come closer to inverting, given the close correlation between slowdowns and inversions over several decades.
Yields on U.S. Treasury paper with two years to maturity are now just 22 basis points below yields on 10-year notes, the narrowest gap since a few months before the start of the last recession in December 2007.
The yield curve exhibits strongly cyclical behaviour, with a large negative gap during economic slowdowns and a smaller negative gap or even a positive one during expansions.
To some extent, whether or not the curve actually inverts is arbitrary, since there is no special significance in the zero line, and the long-term average has been around 105-115 basis points.
So the current gap is already in the 82nd-83rd percentile of the long-term distribution across multiple cycles since 1983, and the is economy already well into the cycle’s boom/tightening phase.
It is not possible to predict either the precise timing or the depth of the next slowdown, but the narrowing yield gap indicates the distribution of risks over the next couple of years is now skewed to the downside.
There are more scenarios in which something could go wrong (accelerating inflation, an emerging markets crisis, monetary policy errors, or a deterioration in corporate finances) and fewer in which everything goes right.
The current yield gap is consistent with a wealth of other indicators, including purchasing surveys, consumer confidence, unemployment, retail price inflation, freight movements and the escalation in share prices.
They all point to an economy approaching a cyclical peak, and then likely to move into a period of more moderate growth, if not recession, over the next 12 to 24 months.
The critical question is whether the next slowdown, when it comes, proves just a pause in an otherwise sustained expansion (1994/95) or marks an end to the current cycle and start of a new one (2000/01 or 2007/08).