Views From the Floor

What could happen if the Federal Reserve did implement precautionary rate cuts?; and the reasons not to read too much into the UK construction PMI number.

 

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The Sahm Indicator

Economist Claudia Sahm posits that when the US 3-month average unemployment rate rises by at least 50 basis points relative to its previous 12-month low, the US economy has entered a recession. The ‘Sahm Indicator’ has proved to have considerable robustness – it has correctly identified every recession since 1970 with no false positives (Figure 1).

We highlight the Sahm Indicator because we are seeing an uptick in the US unemployment rate, from a low of 3.6% at the end of May to 3.7% at the end of June.¹ Whilst this leaves us 40bp away from the 4.1% threshold that would trigger the indicator, we still believe it’s worth watching.

One might initially think that 4.1% unemployment is not a particularly big deal – after all, it would be a low reading in historical terms. However, we believe that what matters is not the level of initial reading, but instead the rate at which unemployment increases. A June paper by the Hamilton Project highlighted that between November 2000 and June 2001, unemployment rose from 4% to 4.5%. Both readings would be low in terms of historic unemployment figures, yet a recession still occurred.

Figure 1: The Sahm Recession Indicator
Unemployment Rate (3-Month Average) Relative to Prior 12-Month Low

Source: Current Population Survey, Bureau of Labor Statistics 1970-2019; Sahm 2019.
Shaded area denotes recessions. Dashed line denotes proposed recession indicator threshold of 0.50.

Bond Extremes – Volatility and Liquidity

Rising bond market realised volatility (Figure 2) and tightening liquidity (Figure 3) may be signalling a potential bond market tantrum. In our view, the current situation is reminiscent of the build-up to previous bond market wobbles in April 2013, October 2014 and April 2015. A back-up in yields would also be consistent with our previous analysis of market moves during precautionary rate cutting cycles.

We are currently at the 99th percentile in terms of returns; indeed, the JPM USD Global GBI 3-month annualised performance (of 17%, Figure 4) and Sharpe ratio (of 7x, Figure 5) are close to post-Lehman extremes. From this point on, our analysis indicates that this is a sell signal with a 71.2% probability of negative returns.

Figure 2: Three-Month Annualised Daily Volatility, US Treasuries

Source: Bloomberg, Man Group; as of 5 July, 2019.

Figure 3: Ten-Year UST Futures, Size of Tightest Three Bids and Asks Each Day in Number of Contracts

Source: JPMorgan; as of 5 July, 2019.

Figure 4: Three-Month Annualised Returns, JPMorgan GBI Global USD Index

Source: Bloomberg, Man Group; as of 5 July, 2019.

Figure 5: Three-Month Annualised Sharpe Ratio, JPMorgan GBI Global USD Index

Source: Bloomberg, Man Group; as of 5 July, 2019.

Air Supply

One early warning of Federal Reserve cuts to come is the supplier deliveries component of the US manufacturing purchasing manufacturers index (‘PMI’). The component measures purchasing managers’ perception of whether their suppliers are servicing them more or less efficiently: above 50 means they’re getting more efficient and vice versa. Qualitatively, the metric is a good gauge of how slickly the economy is running. Suppliers may stutter for any number of reasons – e.g. lack of skilled labour, restrictive access to credit, aging capital stock etc. – but when they do, our prior is that the Fed will be quick to grease the wheels with monetary accommodation.

There is some quantitative support for this theory: in Figure 6, we shade in blue the periods where supplier deliveries was under 50 for two consecutive months or more. In Figure 7, we detail what happened to the base rate around that point. Nothing happened in the last three instances, but that’s not surprising: there was nothing left to cut. In all of the other instances, cuts quickly followed – often simultaneously it must be admitted, but usually in a protracted manner.

So, we’re watching the indicator quite closely at the moment: at 50.7 as of June 2019, it’s not yet breaching the rule, but it’s fallen rapidly from a peak of 67.6 12 months ago.

Figure 6: Supplier Deliveries and the Fed Funds Rate

Source: ISM, Bloomberg, Man Solutions, as of 28 June, 2019. Shaded areas are where Supplier Deliveries are below 50 for two consecutive months or more.

Figure 7: Instances of Two or More Consecutive Supplier Deliveries Readings of 50 or Less

Source: Man Solutions; as of 28 June, 2019.

With contribution from: Ed Cole (Man GLG, Managing Director) and Henry Neville (Man Solutions, Analyst).

1. Bloomberg.