Pedestrians walk along Wall Street near the New York Stock Exchange (NYSE) in New York, U.S., on Thursday, May 16, 2024.
Alex Kent | Bloomberg |
Wall Street's favorite recession signal started flashing red in 2022 and hasn't stopped since – and has been wrong at every turn so far.
The return on the 10-year Treasury bond was lower than most of its shorter-dated counterparts during this period. This phenomenon is known as an inverted yield curve and has preceded almost every recession since the 1950s.
Although it is commonly assumed that a downturn should occur within one or two years at the latest after an inverted curve, not only has one not occurred, but there is no red number in sight for US economic growth.
Given this situation, many on Wall Street are wondering why the inverted curve – which is both a signal and, in some ways, a cause of recessions – was so wrong this time and whether it is a continuing sign of economic danger.
“So far, it's been a blatant lie,” said Mark Zandi, chief economist at Moody's Analytics, half-jokingly. “It's the first time it's been reversed and not followed by a recession. But I don't think we can be comfortable with the continued reversal. So far, it's been wrong, but that doesn't mean it will be wrong forever.”
Depending on which maturity point you think is most relevant, the curve has been inverted either since July 2022, as measured by the 2-year yield, or since October of the same year, as measured by the 3-month yield. Some even prefer to use the federal funds rate that banks charge each other for overnight loans, which would make the inversion last until November 2022.
Whichever point you choose, a recession should have set in by now. The inversion has only been wrong once, in the mid-1960s, and has predicted all austerity measures since then.
According to the New York Federal Reserve, which uses the 10-year/three-month curve, a recession should occur about 12 months later. In fact, the central bank still sees about a 56% chance of a recession occurring by June 2025, as the current gap shows.
“It's been so long that you have to start wondering about the usefulness of the curve,” said Joseph LaVorgna, chief economist at SMBC Nikko Securities. “I just don't understand how a curve can be so wrong for so long. I'm leaning towards it being broken, but I haven't completely surrendered yet.”
The reversal is not alone
The situation is further complicated by the fact that the yield curve is not the only indicator that gives cause for caution about the duration of the post-Covid recovery.
Gross domestic product, the sum of all goods and services produced in the expanding U.S. economy, has grown by an average of about 2.7 percent per quarter in real terms on an annualized basis since the third quarter of 2022 – a fairly robust pace that is well above what is considered trend growth of about 2 percent.
Before that, GDP was negative for two consecutive quarters, meeting a technical definition, although few expect the National Bureau of Economic Research to declare an official recession.
The Commerce Department is expected to report on Thursday that GDP rose 2.1% in the second quarter of 2024.
However, economists are observing several negative trends.
The so-called Sahm rule, a fail-safe measure that assumes recessions occur when the average unemployment rate over three months is half a percentage point higher than its 12-month low, is about to be triggered. In addition, the money supply has been steadily declining since its peak in April 2022, and the Conference Board's index of leading indicators has been negative for a long time, suggesting significant headwinds to growth.
“Many of these policies are being questioned,” said Quincy Krosby, chief global growth strategist at LPL Financial. “At some point we will be in a recession.”
But a recession is not in sight.
What is different this time
“We have a number of different indicators that just didn't pan out,” says Jim Paulsen, a veteran economist and strategist who has worked at Wells Fargo, among other places. “We had a number of things that resembled a recession.”
Paulsen, who now writes a Substack blog called “Paulsen Perspectives,” points to some unusual occurrences in recent years that may be responsible for these differences.
On the one hand, he and others point out that the economy had indeed experienced a technical recession before the inversion. On the other hand, he points to the unusual behavior of the Federal Reserve during the current cycle.
Faced with runaway inflation at its highest level in more than 40 years, the Fed began gradual interest rate hikes in March 2022, then became much more aggressive in the middle of the year – after inflation peaked in June 2022. This is contrary to how central banks have acted in the past. In the past, the Fed raised interest rates at the beginning of the inflation cycle and then began cutting them later.
“They waited until inflation peaked and then radically tightened monetary policy. So the Fed was completely out of step,” Paulsen said.
But interest rate dynamics have helped companies avoid what normally happens when the curve inverts.
One reason inverted curves can both contribute to and signal a recession is that they make shorter-term funds more expensive. This is hard on banks, for example, which borrow short-term and lend long-term. If an inverted curve hurts their net interest margins, banks may decide to lend less, leading to a drop in consumer spending, which in turn can trigger a recession.
But this time, companies were able to lock in low long-term interest rates before the Fed began raising rates, giving them a buffer against higher short-term rates.
For the Fed, however, this trend also means more, as much of this financing will soon be due.
Companies that need to refinance their debt could have an even harder time if the prevailing high interest rates remain in place. This could be a kind of self-fulfilling prophecy for the yield curve. The Fed has left its benchmark interest rate unchanged for a year and is at a 23-year high.
“So it could well be that the curve has been lying to us so far. But it could soon decide to tell the truth,” said Zandi, the Moody's economist. “It really makes me uneasy that the curve is inverted. That's another reason why the Fed should cut rates. They're taking a risk here.”
Comments are closed.