Morgan Stanley warned Tuesday that the U.S. is coming dangerously close to a recession as renewed trade tensions and a slump in economic data put U.S. profits and economic growth at risk.
“Recent data points suggest US earnings and economic risk is greater than most investors may think,” wrote Chief U.S. Equity Strategist Michael Wilson, CNBC reported.
Many recent reports reflect April data, “which means it weakened before the re-escalation of trade tensions,” Wilson continued. “In addition, numerous leading companies may be starting to throw in the towel on the second half rebound--something we have been expecting but we believe many investors are not.”
Wilson adds that market risks have been reflected in the bond market, pointing to an unusual phenomenon in government debt yields.
A key slice of the Treasuries yield curve is falling deeper into inversion as growing angst over trade friction is overshadowing expectations that the Federal Reserve will cut interest rates by year-end.
The gap between 3-month and 10-year rates dipped Tuesday to negative 9.2 basis points. That’s the most negative since March, when this closely watched segment of the curve inverted for the first time since 2007. Gaps between most other sectors of the curve have narrowed as well. Historically, an inverted curve has been a signal that a recession is looming.
Haven buying drove the 10-year yield to the lowest in 19 months on Tuesday after comments from President Donald Trump further dimmed the prospects of a U.S.-China trade deal. Renewed tensions in Europe also damped demand for riskier assets.
The flattening trade faces risks, including Friday’s release of the Fed’s preferred inflation gauge, which is forecast to hold below officials’ 2% target. Another low reading could spur traders to price in more rate cuts in 2019, potentially resteepening the curve.
“Adjusting the yield curve for QE and QT shows a persistent inversion for the past ~6 months, suggesting recession risk is higher than normal,” Wilson said.
“The adjusted yield curve inverted last November and has remained in negative territory ever since, surpassing the minimum time required for a valid meaningful economic slowdown signal,” Wilson said. “It also suggests the ‘shot clock’ started 6 months ago, putting us ‘in the zone’ for a recession watch.”
To be sure, concerns about the U.S.-China trade war and Italy's budget policy sent benchmark U.S. Treasury yields to their lowest levels since September 2017 on Tuesday and helped fuel demand for Treasury Department debt auctions, Reuters explained.
U.S. President Donald Trump said on Monday that Washington was not ready to make a deal with China, but he expected one in the future.
At the same time, he pressed Japanese Prime Minister Shinzo Abe to reduce Japan's trade imbalance with the United States. The European Commission, meanwhile, could impose a 3 billion euro ($3.36 billion) fine on Italy for breaking EU rules due to its rising debt and structural deficit levels, the country's Deputy Prime Minister Matteo Salvini said on Tuesday.
Salvini, whose far-right League party triumphed in European elections on Sunday, said he would use "all my energies" to fight what he said were outdated and unfair European fiscal rules.
"It's very much the usual suspects in terms of the drivers behind the risk off sentiment," said Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets in New York. The safe haven bid for U.S. debt helped the Treasury sell $81 billion in two-year and five-year notes to strong demand, even with two-year yields near their lowest levels since February 2018 and five-year yields at the lowest since December 2017.
A $40 billion sale of two-year notes had the strongest demand in nine months, with a bid-to-cover ratio of 2.75. "The two-year auction is a reflection of the overall strength of the market even as yields have hit new cycle lows," said John Canavan, an analyst at Oxford Economics in New York.
A $41 billion sale of five-year notes was solid, if not as strong as the two-year note auction. The notes had a bid-to-cover ratio of 2.38, below the 2.44 level reached at the prior five-year note auction held in April. The Treasury will also sell $32 billion in seven-year notes on Wednesday.
Concerns about global growth, in part due to international trade tensions, and tepid inflation has increased expectations that the U.S. Federal Reserve will cut rates this year. Interest rate futures traders are pricing in an 80% chance of a rate cut by December, according to the CME Group's FedWatch tool.
Material from Bloomberg and Reuters has been used in this report.
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