Chance of U.S. recession climbing with current headwinds

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Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

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Jeffrey Mayberry, fixed-income asset allocation strategist and portfolio manager at DoubleLine Capital 

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The first half of the year had a pretty good return for fixed income, or at least on the U.S. side. We had about a 4% return on the U.S. Agg [Bloomberg U.S. Aggregate Bond Index] in the first half of the year, and a 1.2% return in the second quarter. It was interesting on the U.S. Treasury curve in the second quarter, you had a pretty good steepening of the Treasury curve, with the two-year down actually 16 basis points, while the 10-year was actually up two basis points, and the long bond was up 20 basis points. 

So, this kind of weird steepening pivot around that 10-year point of the curve is something we’d been expecting, something that we were putting on in our portfolios. But it’s really much more of a move towards the idea that over the long term — and the long-term Treasury’s reflecting this — there are some fiscal problems in the U.S., and that’s really putting upward pressure on longer-term interest rates. 

You have seen, interestingly enough though, credit continuing to do well. Credit spreads have continued to grind in. Certainly, there was a lot of volatility around tariffs and what’s going on in Congress in the U.S. But overall, point to point, spread’s grinding in tighter. Really, if you look at your riskier credits, your high yield was up 2.5% on the quarter. It’s almost doubling the return of the Agg and, your bank floating rate side was up 2.8%. 

Really, the question going forward is, what’s going to happen with inflation, and what’s kind of priced in with inflation? I like to look at inflation swaps. They don’t have the supply/demand dynamics that you do see in Treasury inflation-protected securities. The TIPS really gives you a pure view on inflation. 

And over the shorter term — call it one to two years — zero coupon inflation swaps are pricing in higher inflation, but over the medium to longer term, inflation is coming back down towards a more normal level. If we look at it, we say, yes, that makes sense to us. The tariffs, no matter what level they’re implemented in, will lead to short-term higher inflation, whether it’s year-over-year or maybe a couple years, but shouldn’t affect things over the medium term. 

But really, when we look at it, we think the risk is to higher inflation. The Fed continuing to say inflation is a level that is unacceptable. And so that’s really the risk: that higher inflation. 

No rate cuts at the end of July seems pretty reasonable. But really — and this has been the case throughout the entire year — the probability of rate cuts is continuing to drop. We’re about 65% chance of a rate cut in September. And the first rate cut is continuing to be pushed out. It wouldn’t surprise me if we get, after the July meeting, the September rate probability goes down. And then October rates continuing to come down. And really, you’re at a place where inflation is still at top of mind, given what’s happened over the past five years. And that mindset has to switch in people in order for them to be comfortable with inflation. So I think the risk is to higher inflation. And it’s kind of being priced into bonds, but maybe not to the same extent that we are expecting. 

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There’s two things to think about here in terms of where we are, in terms of the economy and the credit cycle. Are we going into a recession? There’s kind of two trains of thought here. One is that if you look at the corporate credits, our corporate credit team tells me that earnings are very strong. There’s really a very low probability of defaults over the medium term. And even with the volatility around tariffs — whether the tariffs are going to be implemented or not — the corporations are very strong. 

Now, if you take a step back from the corporate credit side of things, and you look at the labour market, the labour market in the U.S. is starting to maybe show some signs of weakness. The jobless claims number is continuing to go up every single week, not to levels that you’re worried about yet, but the trend is something where we’re probably at a yellow light. “Let’s kind of keep an eye on them and see whether they continue to get worse or not.” But not at a “OK, we’re getting a recession!” level. 

The payroll data continues to be relatively strong, and so you really haven’t seen too many signs of that hard data mirroring the soft data, the sentiment data, that has been looking not terrible, but not great either. There are some signs of maybe a recession on the horizon. We don’t think it’s coming this year as we’re past the first half of the year already. We’re running out of time for there really to be a recession in 2025. But if you kind of say, what’s the probability of recession over the next 12 months, I would say we’re in a little bit higher than average, probably 60% probability of recession in the next 12 months, where it seems like the markets are pricing in a 40% chance of recession. So, we’re kind of inversed flip-flop on what markets are pricing in. 

There are some worrying signs, nothing where we are advocating for selling credit, especially since that corporate credit is continuing to remain strong and earnings are going to remain strong. But something just to keep an eye on, something to have your hand close to the ready button, and ready to make potential moves, depending on whether the data worsens or strengthens from here. 

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Canadian fixed income and the Canadian economy overall is at a very interesting place here relative to the U.S. And I think most of that’s because the U.S. is trying to decouple themselves from not only Canada, but everywhere else around the world. It used to be that a lot of the developed economies would move along with whatever the U.S. economy did — or at least that was the case over the post-World War II era — and I think that those correlations are still going to be relatively high, but I think the correlations of the future, at least over the medium term, are going to be lower. 

To the extent that, OK, the U.S is going to go into recession, you know, 60% chance of recession, I would discount that level from a Canadian fixed-income side, and maybe look at Canadian fixed income being a potential buying opportunity to move into those types of non-dollar trades, whether it’s in Canada or anywhere else around the world. 

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Because we’re at an interesting point in time, I think there are pockets of opportunity for fixed-income investors through the end of the year. You’re looking at something like structured credit, whether it’s in residential mortgages, commercial mortgages, asset-backed securities. While those spreads have come in and tightened, we think the probability of default is relatively low, and those spreads still give you some advantages over your investment-grade corporate bonds or higher up the credit stack in your high yield, your double-B high yield. You get some more yield, similar amounts of risk, similar amounts of volatility. So we think that’s a very good opportunity for investors. 

Also, given the moves in the U.S. dollar versus the global markets, we think it could be a good time to invest in some non-dollar names. Start legging into those trades. But certainly that’s a potential opportunity, given the market outlook for the dollar, and really try to take advantage of some of that volatility that happens in the non-dollar names, whether it’s in the sovereign space or in the local currency emerging market space. 

And finally, given our outlook for things, we do think that The Fed is more likely to cut rates, not necessarily over the short term, but we think that The Fed is more likely to cut than to hike. And so, have a little bit more of that exposure to the lower end of the Treasury curve, and less exposure to the longer end of the Treasury curve. 

The Treasury curve, on the long end, hasn’t really reacted too much to the Congress passing tax cuts, and a $5 trillion debt ceiling adjustment and the idea of deficits continuing to expand, but we think over the long term, certainly, that pressure is going to continue to push up longer term interest rates higher than they would be if the U.S. Congress got their fiscal house in order. We don’t think that that’s a very likely scenario — at least until they’re forced to buy the bond market — but certainly, that upward pressure on long-term interest rates would force that move, but it’s going to be significantly higher from here. 

So if you were to look at the Treasury curve, we like the short end of the curve. We don’t like the longer end of the curve. And if you are at a place where you can buy shorter-duration assets, we think that those two-year type assets, whether it’s the two-year Treasury curve or shorter duration structured credit, it’s going to do well in that scenario where the shorter end of the Treasury curve rallies and the Fed is cutting rates, whether it’s from a idea of recession coming or the idea that The Fed is just trying to, kind of, more normalize rates. Certainly the Fed is more inclined to cut rates very slightly from here versus raise rates. 

And so those are kind of the places we like in the market today. Picking and choosing, I think the volatility that we saw in the second quarter could continue here over the rest of the year, and provide some opportunities to pick up some relatively cheap bonds, and try to take advantage of some dislocations in the markets to provide good yielding, good spreading assets with very lower amounts of risk.

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