ISMs and Recession

The bad news from the latest ISM indices is that growth in both the manufacturing and service sectors has slowed.  The good news is that these reports have displaced the yield curve as presumptive recession signals.  Until a few weeks ago, the inverted yield curve was cited almost hourly as a clear recession signal.  Now that the curve is no longer inverted, attention has shifted to the ISM data.

While the ISM indices have been better leading indicators than the yield curve, they have not been perfect (no one indicator ever is).  The recent declines are somewhat similar to the 2016 experience.  The manufacturing index fell from 59 in 2014 to 50 in late 2015 to 48 in January 2016.  The service sector index also declined over those months to a low of 51.8 in 2016.  By 2017, however, both indices had begun to rebound sharply.  The manufacturing index reached 60 by September 2017 and the service sector index reached 59.

Treasury yields fell as those indices weakened, as they have recently.  The yield on the 10-year note dropped from 2.40% in 2015 to 1.38% in early July, 2016.  The 30-year bond yield fell to 2.10% in July 2016.  By year-end 2016, however, those yields had increased more than 100 basis points.

While economic growth is not likely to rebound as strongly in 2019-20 as it did in 2016-17, there is a strong possibility that the ISM indices are bottoming now.  The new orders components have stopped declining, and other leading indicators such as initial claims, consumer confidence, auto sales and housing data are improving or are at very healthy levels.  And, if the ISM indices turn upward in the months ahead, Treasury yields will very likely do the same.

Total returns in September were examples of how the markets typically react when the economic data surprise on the upside.  The Treasury market posted a total return of -0.9%, led by a -3% return from the long bond.  TIPS returned -1.5%.  The muni market returned -0.7% and investment grade corporates returned -0.6%.  High yield corporates recorded a positive 3% return, but the weakest segment, the CCCs, had a zero return and a -2.3% return for the quarter.  While the BB credits have a YTD return of 13%, the CCCs YTD return is only 6.1%.  Just as in the stock market, investors appear to be shifting away from the riskiest issuers.

A final word about the jump in repo rates last month.  One factor was that dealers had taken down lots of the notes and bonds in the recent auctions and those positions had to be financed.  If this recent pattern of weaker investor demand confronting a heavy pace of Treasury borrowing were to persist, one would expect some downward pressure on prices now through year-end.  And, with yields again near all-time lows and durations very long, only modest yield increases produce significant negative returns.

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