The yield spread on U.S. 10-year to two-year Treasury bonds finally came out of inversion after 787 days on Aug. 30. For more than two years, its inversion – when short rates are higher than long rates – had been cited countless times in investing and economic circles as reason to believe a recession was about to get under way.
But that recession has not arrived. At least not yet.
Forecasters who were predicting a soft landing and no recession have declared victory. The rally in equity markets last month seems to reflect that jubilation.
Those who were more pessimistic point out that post-Second World War recessions usually only begin after an inversion ends and the yield curve has normalized. They also correctly point out that there is a lag between when we enter a recession and when we get the data confirming one, which is defined as two consecutive quarters of overall gross domestic product (GDP) growth below zero. Furthermore, some parts of the yield curve are still in inversion.
One reason we are not yet seeing the effects of an inverted curve is because after years of historically unprecedented lows, corporations and others borrowed at longer terms to maturity than in the past. Companies and real estate borrowers have had a cultural change since the 1980s and 1990s and are less leveraged, and have stronger balance sheets. Therefore, rising rates have taken longer to have an effect.
Nevertheless, this debate will linger on. All we know is that a recession will arrive at some point. What is more important is that Western economies have been unable to show any kind of sustainable, robust growth.
A technical recession, like we typically have had in the past, is cyclical. We are having a secular problem. And this is all leading to political issues that may very well get worse.
The inverted yield curve has been an excellent indicator of a recession because central banks typically raise short-term rates to curtail inflation and an overheating economy. Bond traders then anticipate future economic weakness and proceed to buy longer-term issues, which tends to push their prices up and yields, which move inversely, lower.
I’ve used the yield curve as an indicator in my trades since 1981. This time, perhaps, it’s possible the United States may escape a recession in the near term.
But the outlook is murkier elsewhere in the West. Canada, as well as the United Kingdom, France and other European nations, are in a state of economic sclerosis.
Here at home, GDP per capita on a purchasing power parity basis has declined for years. Most Canadians are getting poorer and have been for years. Meanwhile, the British are about 10 per cent less well off than they were before the Great Financial Crisis of 2008. The same is true for many parts of Europe.
The social upheavals in Europe and, to some extent, North America reflect struggling individuals seeing their economic fortunes deteriorate. Blaming the situation on right-wing or left-wing ideologues misses the point. These movements are gaining strength owing to a struggling economy, and not YouTubers brainwashing the hapless public.
In other cycles, inflation increases coincided with a booming economy. The recent spike in inflation was owing to a rapid increase in money supply as a response to COVID payments. Unlike past accelerations of inflation, it was not preceded by an organic overheating of demand. Consequently, it is totally understandable and rational that the yield curve indicator would not work the same way this time.
This economy is different from the past. Government employment has risen while manufacturing jobs have not. Migration has surged and, in Canada’s case, the population has been exploding. Bluntly, the productivity of new arrivals is less than optimal owing to a variety of factors such as a lack of opportunities compared with previous generations and a mismatch of skillsets. The percentage of the population with university degrees has doubled in the past 40 years, and most of those degrees are in the humanities that give younger people less productive job skills while our economy struggles with a shortage of skilled tradespeople. Consequently, economically stimulative policies may not be as effective as in the past, especially with high government debts.
We need to stop obsessing about the technical definition of a recession and focus on how, if possible, we can cure our economic sclerosis. We need to incentivize productivity, cut government spending, lower taxes and cut regulations.
History teaches us that failing economies result in either civil strife, or in authoritarians taking power to deal with potential upheavals. Neither option seems appealing. Hopefully, this time things really will be different.
Investors need to prepare for lacklustre returns in many Western countries and be diversified. We are entering a capital preservation period.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.
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