Macro Signposts | 7 August 2024

Unless explicitly stated, views expressed do not constitute official PIMCO views.

Despite Macro Signals, U.S. Likely Isn't in Recession

Over the last several days, markets have moved violently. What started as a decline in the Japanese equity market, coinciding with the strengthening of the yen, has spread to global equities and rates markets. A weaker-than-expected U.S. employment report, including a higher unemployment rate that meets the technical definition of the Sahm Rule recession indicator, exacerbated the market volatility and contributed to calls for the Federal Reserve to quickly cut interest rates by increments usually not seen outside of recession.

Amid this unsettling market environment, we wanted to offer our views and analysis on the U.S. economy, including the labor market, recession risks, and associated monetary policy.

The punchline is we don't think the U.S. economy slipped into recession in July - what the Sahm Rule (more on this below) is supposed to indicate. Our read of a broader range of economic data is that real GDP growth is downshifting from an elevated roughly 3% pace in 2023 to a below-trend 1% to 1.5% pace now. A combination of weaker immigration, waning fiscal policy supports, and a loss of momentum in global manufacturing growth all point to a loss of overall economic momentum.

At the same time, inflation risks now look much more balanced. The ratio of job vacancies to unemployed workers is back to pre-pandemic levels, reflecting a still healthy U.S. labor market. Thus, unit labor cost inflation is now more consistent with price level inflation remaining in a "two-point-something" zone - sustainably near the Fed's 2% target.

Given this background, there are good reasons for the Fed to return policy to neutral more quickly than previously thought. The Fed's own forecasts as of the June meeting imply that policy will remain restrictive through 2026, which in our view now looks misplaced.

However, without broader evidence that the economy is quickly falling into recession, we doubt the Fed will announce emergency cuts ahead of the September meeting (something the fed funds futures market started to price). Although a 50-basis-point cut at the September meeting is possible, it will depend on economic and financial market developments between now and then - and we see good reasons to believe that headline payrolls will rebound in August after disappointing in July. This makes the roughly 90% probability of a 50-bp cut implied by fed funds futures contracts (as of this writing on 6 August) seem aggressive.

A little further out the curve, the implied 3% yield of fed funds futures expiring in December 2025 looks more reasonable for a baseline that the Fed returns policy closer to neutral by the end of 2025, with some yield premium for the possibility that the U.S. economy falls into recession. Meanwhile, intermediate real rates still look attractive relative to estimates of the real neutral interest rate and are likely to provide a hedge against a further sell-off in risk assets. For reference, the five-year real rate, five years forward (5y5y) as of this writing is yielding 1.7% vs. PIMCO's New Neutral range of 0% to 1% real.

To help articulate the macro outlook that underpins these market views, here are our answers to common questions today around the U.S. economy.

Q: What is the Sahm Rule, and what does it signal?

A: The Sahm Rule is an economic indicator developed by economist Claudia Sahm. It states that a recession is likely underway if the three-month moving average of the national unemployment rate rises by 0.5 percentage points or more relative to its low during the previous 12 months. The Sahm Rule has successfully flagged every recession since the 1950s.

Based on the July unemployment data, the rule was technically not triggered - the change in the three-month moving average unemployment rate was 0.493 percentage points on an unrounded basis. However, it was close enough. Based on the historical statistical relationship, the Sahm Rule suggests the U.S. economy slipped into recession in July.

Q: Is the U.S. economy currently in recession?

A: We don't think so. More precisely, we don't think the National Bureau of Economic Research (NBER) will eventually date July 2024 as the start of a U.S. recession. The Sahm Rule may currently be a less reliable signal due to the surge in immigration (though it has slowed considerably in 2024) and more general labor supply gains over the last few years.

The change in the unemployment rate can be broken down into various labor market flows, including a flow of people who lost their jobs, and a flow of people who were previously not looking for a job - and were therefore considered out of the labor force - who are once again looking. Immigrants who have come into the country eligible for work permits would also be captured as new entrants into the labor market if they are actively looking for a job.

Over the last year, around 60% of the rise in the U.S. unemployment rate was related to labor market new entrants or reentrants - something that hasn't happened in any past instances when the Sahm Rule was triggered. In fact, employment levels haven't declined materially, although the unemployment rate has risen. According to the household survey, unemployment levels have been more or less flat over the last year, while the establishment survey suggests they are up 2.4 million. Each survey is likely being distorted by various factors, and the true levels are likely somewhere in the middle, but the bottom line is that the rise in the unemployment rate hasn't been characterized by broad-based layoffs. This is also consistent with unemployment insurance claims data, as well as the WARN data (named for the Worker Adjustment and Retraining Notification Act), which tabulates company layoff announcements and tends to lead unemployment insurance claims by around three months.

Figure 1 below shows longer-term trends in U.S. labor markets along with the Sahm Rule indicator.

Figure 1: Decomposing the Sahm Rule: New job seekers vs. permanent job losers

Chart01

Source: Federal Reserve Bank of St. Louis, U.S. Bureau of Labor Statistics (BLS), and U.S. National Bureau of Economic Research (NBER) as of 31 July 2024. The Sahm recession indicator signals the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months. Shaded areas indicate U.S. recessions as defined by the NBER.

The fact that the level of employment hasn't declined materially is important for recession dating, because the NBER - the U.S. committee charged with officially declaring economic peaks and troughs - considers the level of employment (not the unemployment rate), along with other variables, when defining recessions. Based on all these coincident economic variables, U.S. growth appears to be moderating but still positive.

Q: What is the chance the U.S. economy does fall into recession? Doesn't that usually happen when the central bank enacts restrictive monetary policy?

A: Yes, historically that's been the case, but a few factors may mitigate that risk today. Based on a sample of 140 historical rate hiking cycles, a recession occurred at some point within three years of the start of the rate hiking cycle in 70% of the cycles. More encouragingly, the 30% of cycles that managed to avoid a recession held three common traits that have also have similarities to today: A positive supply shock coincided with the cycle, inflation came down quickly, and the central bank then cut quickly. Post-pandemic global supply in both labor and goods markets has recovered, and the U.S. has had much better productivity growth than its developed market peers. Although the post-pandemic inflation surge was shocking and painful for many, and the road to lower inflation has been bumpy, inflation has actually normalized quickly relative to historical inflationary episodes. The only question now is how quickly the Fed will cut. After recent data and market developments, we see reason to believe that it will cut more quickly than it has been indicating.

Taking the average across historical U.S. business cycles, in any year the average risk of recession has been 15%. Given today's data and trends, and accounting for historical experience around cutting cycles, recession risks are perhaps about twice that historical average.

Q: How much do central banks usually cut when faced with a recession? How about in nonrecessionary cutting cycles?

A: Since the 1960s, central banks have cut on average 500 bps when their cuts coincided with a recession. The historical average non-recession cutting cycle is characterized by around 200 bps of cuts in the 18 months after the first cut (with some 50-bp cut increments sprinkled in). That is pretty close to what is now implied by the 2025 fed funds futures yield of 3% (as of this writing), implying the rates market has now priced a cutting cycle that is very typical historically, but could still price steeper central banks cuts if recession risks did increase materially.

Q: What could drive the economy into recession?

A: Any number of unforeseen shocks could drive the U.S. economy into recession. We are also cognizant that negative sentiment in financial markets, falling equity prices, challenged areas of credit markets, and increasing bank funding issues all could accelerate the downturn. The good news is that private balance sheets - both household and corporate sector - are in good shape on average. Still, it will be important to monitor and manage these risks.

Q: What's the bottom line?

A: The abrupt and volatile repricing across markets over the last week or so was likely exacerbated by summertime liquidity conditions and stop outs of leveraged bets. We don't think it reflected the U.S. entering recession in July, although U.S. growth is certainly downshifting.

Nevertheless, in the U.S. rates market, outside of the very short-dated fed funds futures contracts where the implied path of Fed policy is arguably aggressively priced, the 18-month-out horizon looks more consistent with an average non-recessionary cutting cycle, where the central bank normalizes quickly but not as quickly as in recession. Despite this repricing, we think intermediate sector bond yields look attractive (we mentioned the 5y5y) for investors who take a longer-term view, and as the bond market demonstrated over the last few days, bonds likely still offer a good hedge against volatility and poor performance in risk asset markets.

Learn about the market dispersion playing out across monetary policy and financial markets in our new PIMCO Perspectives, "Summer of Dispersion."

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We welcome your questions about the global macro landscape. Don't hesitate to suggest themes or data for us to analyze and discuss: Please email [email protected].

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