Recession fears have so far largely focused on the United States. However, a recent note from Capital Economics to its clients predicts that we are much more likely to see a recession in Europe.

Are US recession fears really valid?

Recession fears among most U.S. economists stemmed from the brief reversal last month in the spread between two-year and 10-year U.S. Treasury yields. Historically, this curve has inverted before every US recession over the past 50 years. In fact, there was only one significant false positive, and that was in 1998.

As expected, economists warned that ignoring the yield curve would essentially be “betting against history”. However, CE suggests that large-scale asset purchases by central banks over the past decade have skewed the dynamics of the curve. In their view, this disconnected the relationship between short and long-term returns.

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A closer look at the numbers

Consider the “short-term” two-year chart instead of the 90-day one. In doing so, it becomes clear that the relationship between the 2 and 10 year chart is in fact showing no reversal. By the logic of most economists, this does not indicate a coming recession. At least not Again.

CE also reported that US household balances are exceptionally strong from a historical perspective. They go on to suggest that it is much more likely that tougher Fed policy will soon interfere with easing post-COVID supply chain friction. This may cool the economy a bit, but it should help avoid a full recession.

Recession fears the point is across the pond

Unfortunately, the real red flags of recession are in Europe. On the one hand, trend growth is already much weaker there (1% compared to 2% in the United States). This leaves much less room for error. Second, Europe is a larger net importer of raw materials than the United States.

So, as commodity inflation feeds through to prices, inflation is likely to exceed even the historically high estimates currently under discussion. If this were to happen, it would likely lead to deterioration in consumer spending and investment.

Real household disposable income in the United States and the euro zone (Q4 2019 = 100)

Graph reproduced with the kind permission of Capital Economics

Whether Europe falls into a mild technical recession or simply stagnates for 2 or 3 quarters may not make a significant difference in the long term. However, Europe’s underperformance will weigh on global growth, however soft or hard the landing. Moreover, it will likely usher in subsequent years of slower growth than we could have predicted just 6-12 months ago.

Obviously, much will depend on how aggressively the ECB raises rates. Currently, markets are expecting 0.25% by the end of the year, but CE is less confident. Recently, they suggested the first quarterback could arrive as early as July. Such an aggressive tightening could spook an already fragile sentiment. This is especially likely if it comes on top of falling real incomes from high inflation this year.

Metal prices have already been hit by the soaring dollar this week. There were also strong sales of aluminum, copper and palladium, in particular. It’s almost as if the markets have finally become aware of the evolution of the fundamentals.

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