According to Federal Reserve data, the 10-year to two-year U.S. Treasury yield spread inverted on July 6, 2022. This immediately resulted in market observers forecasting an imminent recession. On the surface, this made sense. Previous recessions had been preceded by curve inversions. When short yields traded above longer-term yields, recessions eventually followed most of the time.
Many market watchers, having missed this indicator in past recessions, were quick to jump on this seemingly infallible signal this time. Yet, curiously, here we are almost 21 months later, and the U.S. is not in a recession.
This has caused many pundits, especially highly paid ones who work for major investment companies and appear on financial news networks, to abandon the indicator. They claim their optimism is based on their keen analysis.
I have always been a proponent of the inverted yield curve indicator and will continue to be, even if it is not working this time exactly as it has in the past. Importantly, when some forecasters predicted recession in the past and the yield curve was normal, they turned out to be wrong.
Not all indicators work 100 per cent of the time. And it is premature for the market bulls to declare victory; you may recall many did just that in late 2007 and early 2008, just before the financial crisis took hold. Historically, the period between the initial inversion and the beginning of a recession can take anywhere between nine months and 2½ years to occur. Add to that another quarter or two before the official gross domestic product figures are released confirming the recession. We are not out of the woods yet.
One thing I have noticed with respect to most proponents of the yield curve indicator is that they never seem to ask why it had been so accurate. And are there other factors that coincide with the inversion that are illuminating.
First, I believe that it has been an effective indicator in the past because, in an attempt to slow down an overheating and potentially inflationary boom, the Federal Reserve will raise short-term rates well above current and expected – or perhaps even feared – inflation. Bond traders see this and expect a slowdown coming.
Consequently, they buy longer-term bonds, pushing long-term yields below short-term yields. They are willing to increase their interest-rate risk and the premium they pay for it, expecting major capital gains.
Historically, they have been correct. High short-term yields eventually cause borrowing to be curtailed as debt matures and is rolled over at higher rates.
We must remember that rates were historically at all-time lows two years ago when the Fed started hiking its key policy rate. Interest rates were effectively below inflation for years. Many borrowers locked in those unprecedented low rates for a long period if they were smart or lucky. Therefore, it is logical to expect the indicator to take longer to work than is typical, as debt terms to maturity are long, especially compared with the early 1980s, when people desperately borrowed in the short term and hoped rates would decline.
Meanwhile, one needs to look at other things that were happening in previous periods of inversions. I have analyzed other inversions in the past and, frankly, this time really is different.
The spread between short-term rates and current inflation is dramatically narrower than in the past. Two-year yields are only about 1.4 percentage points above the current U.S. consumer price index. That spread was 3.3 percentage points in June of 1990, and that recession was very mild by historic standards. The spread was about 2.2 percentage points leading up to the financial crisis of 2008, and more than more percentage points leading into the 1981 recession. In fact, rates were slightly higher, and inflation was slightly lower, leading up to the financial crisis, before the Fed did anything. Now, we are well into a cycle of raising rates. Monetary policy is not overly stimulative. Anemic money supply numbers confirm this situation.
The Fed is not as restrictive as it appears when one looks at rates relative to current inflation. This may partially explain why the U.S. economy has shown surprising strength.
Furthermore, in the past, tightening cycles were preceded by economic booms. This time around, growth in the U.S. is below long-term averages. Much of the developed world is not growing or in mild recessions. China seems to be having major issues. No one would seriously suggest that the world economy is booming. The U.S. is an outlier but perhaps not for long. Also, we must remember that the U.S. deficit-to-GDP ratio was 6.2 per cent in 2023, a figure more historically common in a serious recession than a boom. In effect, the U.S. began stimulating its way out of a recession through deficit spending without a recession. This will have unintended consequences that will likely be negative.
Will the U.S. experience a recession in 2024? I would put the odds at slightly more than 50 per cent. Far more importantly and more worrisome is whether the U.S., like Canada and some other unfortunate economies, enters a lost decade or even generation of growth. Remember that Canada has had numerous recessions since the end of the Second World War. In every case, we made up for the fall in GDP relatively quickly.
This time around, we have had six years of essentially zero real growth. Recessions are not the worst things to fear.
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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