Wall Street's favorite recession signal suggests that the economy is in trouble

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Economists and analysts worry long before this prognosis of recession reaches 100%. Indeed, the model of the New York Fed has never reached 50% before the last three recessions, including the crisis of 2008.

"Any overrun by 30% is very bad," said Nicholas Colas, co-founder of DataTrek Research. "Many things have to go well to avoid a recession.We need a trade agreement."

The yield curve measures the spread between bond rates in the long and short term. Normally, it is more costly for the government to borrow for a longer period than for shorter periods. But this relationship has been reversed lately. The so-called reversals took place before previous recessions.

That is why savvy investors pay close attention to the New York Fed's recession forecast.

"The Fed model has become the flagship of this year's group of economic indicators," said Colas. "Everyone is watching this model or has come up with its own version."

However, some have suggested that the yield curve may no longer be a reliable predictor of the recession.

The bond market is operating today under unprecedented conditions. The central banks of Europe and Japan have for the first time dropped interest rates in negative territory. According to Bank of America Merrill Lynch, the 2020s will start with the lowest interest rates in 5,000 years.

In other words, the model of the New York Fed could release a false positive because of the huge distortions in the bond market.

Yet this is only the last worrisome signal suggesting that the longest economic expansion in US history may not survive the US-China trade war.

"Dangerous game"

Earlier this week, a new report showed that the US manufacturing sector contracted in August for the first time in three years. New export orders plunged to levels never seen since 2009.

Although the White House has tried to blame the Federal Reserve, the trade war is the biggest obstacle to the economy at this time. Businesses complain about tariffs, not borrowing costs, which remain historically low.

"Trade policy is risk # 1. If the situation continues to worsen, it is a real threat to the business cycle," said James McCann, senior global economist at Aberdeen Standard Investments.

McCann said that a recession was not his current prediction, but that the risk was increasing.

The United States imposed a 15% tariff on Chinese goods worth $ 112 billion on September 1, which led to further reprisals by Beijing. Additional tariffs are expected to come into effect later this year, although both sides have relieved nervous investors by announcing their intention last Wednesday to hold talks in early October.

"We are locked in what looks like a dangerous climbing game, and we fear the fallout will spread beyond manufacturing," said McCann.

Services sector slows at its weakest pace in three years

Some evidence already suggests that the pain is shifting to the service sector, which accounts for the vast majority of the economy.

According to a report released Thursday by IHS Markit, activity in the US services sector has experienced the slowest growth since March 2016. The job creation rate has slowed to its lowest since February. 2010, the month before the start of economic expansion.

Chris Williamson, Chief Economist at IHS Markit, blamed the "deterioration" on the "spread of the slowdown in manufacturing," which led to a loss of confidence among households and businesses.

US manufacturing sector contracts for the first time in three years

"US companies have registered one of the most difficult months since the global financial crisis," writes Williamson in his report.

However, a competing report released Thursday painted a much more optimistic picture. The Institute for Supply Management said that US service sector activity had rebounded in August and that business owners were "generally positive" about the situation.

The labor market seems to be holding up relatively well, at least up to now. Job creation in the private sector has accelerated to reach 195,000 jobs in August, according to ADP.
"Companies retain their payroll despite the economic downturn," said Mark Zandi, chief economist at Moody's Analytics, in a statement. "Hires have moderated, but layoffs remain low.As long as this continues, the recession will remain safe."

A necessary commercial breakthrough

Nevertheless, economists reduce their growth forecasts because of tariffs. UBS warned this week that the trade war would have made GDP growth below 0.3% in the second quarter of next year.

"This forecast puts into perspective the specter of a recession," wrote Seth Carpenter, chief US economist at UBS.

The hope is that the trade war will calm down before any other damage is caused to the economy. The United States and China plan to conduct trade talks in early October in Washington. The Chinese Ministry of Commerce said the goal was "to conduct high-level negotiations to make substantial progress".

Investors want a breakthrough that will lead to a lasting trade cease that will prevent the next round of tariffs.

The question is whether this will be enough to avoid a recession or if it is already too late.

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