FRED Spread inverted for the first time since 2005

Last Wednesday was the first time since 2005 that the US ‘FRED Spread’ has inverted – this is traditionally seen as reliable, and an early indicator for economic recessions. In basic terms, investors are better compensated for loaning in the US over two years than over ten years (which highlights short term economic risk being priced into two year bonds). This inversion has preceded every recession over the past 50 years, according to research from Credit Suisse, with a recession occurring on average 22 months following a 10-minus-2 inversion.

While the FRED Spread is derived from the US bond markets, developments in the US economy can have consequences worldwide. Trump’s trade war against China has had a negative effect on business sentiment in the US and globally, and there are fears that the slowdown in the world economy will wreak havoc upon the US economy even further.

What makes this all so interesting is that the US (and world) economy is still dealing with the hangover from the Global Financial Crisis 12 years ago. The federal reserve cash rate is already incredibly low by historical standards (currently targeting 2.25%) and is expected to remain low for a long while. If the US market is heading for another recession there will not be much flexibility for traditional monetary policy to stimulate the economy. And with the US federal government already running trillion dollar deficits, Trump may have trouble further loosening fiscal policy to stimulate demand.

What does this mean for Australia?

There are already some signs the Australian economy is slowing down: the Australia Government has a stipulated 2-3% target on inflation, but the current level of 1.6% shows no promise of increasing anytime soon – a fact making economists and regular citizens alike nervous. Additionally, the unemployment rate of 5.3% is above the Non-Accelerating Inflation Rate of Unemployment (NAIRU) of 4.5%. And if that wasn’t bad enough, the Reserve Bank of Australia cash rates are at all time lows, currently at 1% and expecting further reductions. The RBA publicly proclaimed that they are ‘prepared to do unconventional things’ to stimulate the economy. 

Furthermore, a housing market correction in Sydney and Melbourne is predicted to slow down discretionary spending, due to a subversion of the regular wealth effect, now dubbed the ‘Reverse-Wealth Effect’. The reverse-wealth effect refers to the lowered confidence and increased feeling of financial anxiety that can occur in home-owners when house prices fall, resulting in property owners decreasing their spending as they begin to feel their assets are declining. This is a reversal of the standard wealth effect, which refers to an increase in consumption and spending when the value of someone’s assets increase. Put simply, when you think you are worth more, you spend more. When you think money struggles are on the horizon, you reach for your wallet less. 

Australia is a highly globalised economy and any uncertainty from global markets is likely to further dampen local business and consumer sentiment. However we are the lucky country – if there’s a way to avoid recession we’ll stumble upon it just in time.