Recession gauge on Wall Street is also in decline
One of the recession signs that Wall Street favors appears to be malfunctioning. An inverted yield curve, characterized by short-term Treasury yields surpassing those of longer-term government debt, has traditionally been seen as a highly reliable indicator of an impending economic downturn. During each of the preceding eight economic downturns in the United States, this occurrence has taken place prior to the economy experiencing a decline. There have been no obvious or prominent false alarms.
However, at present, that sequence is in jeopardy. The yield curve has seen a prolonged period of inversion, lasting over 400 trade sessions or more according to certain metrics, without any indications of a significant economic downturn. Last month, U.S. firms experienced a substantial increase in employment with the addition of 175,000 positions. Furthermore, it is anticipated that economic growth in the current quarter would surpass that of previous quarters.
Failure to promptly experience a recession could have a lasting detrimental effect on the yield curve’s role as an indicator, serving as a prominent illustration of how the consequences of the Covid-19 pandemic have disrupted long-established beliefs on Wall Street regarding market and economic operations. Despite the recent atypical nature of the past few years, investors are unlikely to be as concerned when another inversion occurs in the future.
“The functionality is not operational,” stated Ed Hyman, the head of Evercore ISI. “Currently, the economy is performing satisfactorily,” although he acknowledged that a recession may be little delayed in occurring this time.
Yield-curve inversions occur before recessions for a specific reason. The yields on Treasurys primarily indicate investors’ anticipations for the average short-term interest rates established by the Federal Reserve throughout the duration of a bond. When the yields of longer-term investments decrease compared to the returns of short-term investments, it indicates that investors anticipate the Federal Reserve will reduce interest rates. This is a common action taken by the Federal Reserve to stimulate a struggling economy.
The inverted yield curve’s reputation as a predictor of economic downturns was not established immediately, but rather evolved over time. Campbell Harvey, currently a finance professor at Duke University, was among the first to draw attention to the correlation between inverted yield curves and economic downturns. In 1986, he wrote a dissertation on this topic.
According to Harvey, discussions on inverted yield curves were place on Wall Street and at the Fed during the 1990s, but it was not until after the 2008 financial crisis that the topic gained more widespread attention. Subsequently, individuals began to evaluate the warning indications that they had previously disregarded.
According to data from Factiva, there was a significant rise in the number of news articles discussing the yield curve inversion in 2019 compared to earlier instances. However, the yield curve has consistently had shortcomings as a tool for forecasting.
A downward-sloping curve suggests that investors anticipate a decrease in interest rates, but it does not clarify the reasons behind their predictions.
Wagers on rate cuts may indicate the possibility of an economic downturn, but they could also suggest the likelihood of a favorable outcome, where the Federal Reserve lowers interest rates as a precautionary step while economic growth remains steady.
Over the years, inversions have mirrored various scenarios. In the early 1980s, the Federal Reserve was not making significant efforts to prevent a recession. Instead, it deliberately increased interest rates to around 20% in order to combat high inflation rates in the double digits.
Alternatively, certain economists argue that a recession may have been prevented if not for external disturbances, such as the sudden increase in oil prices due to Iraq’s invasion of Kuwait in 1990 or the Covid-19 epidemic in 2020.
Given the present circumstances, the possibility of a recession has occasionally appeared probable. In 2022, predictions of an economic decline increased significantly due to the continuous rise in inflation and the Federal Reserve’s aggressive implementation of interest rate hikes.
Nevertheless, certain economists maintained their confidence in the possibility of averting a recession. The proponents contended that inflation may decline to the Federal Reserve’s 2% objective to some extent through the autonomous recovery of businesses from the epidemic, enabling them to increase production and satisfy client demand once more. Although interest-rate rises remained necessary, they may be reversed prior to a significant slowdown in the economy.
Subsequently, there has been a significant decline in inflation, accompanied by a minor increase in the unemployment rate. Investors have been buoyed by the possibility of interest rate reductions in the absence of an economic downturn, resulting in a 24% increase in the S&P 500 last year and an additional 11% increase this year.
Harvey, the economist who is commonly linked to the inverted yield curve, has expressed his belief that the economy has the potential to evade a recession on this occasion.
“To believe that you can accurately predict the intricate U.S. economy using only one indicator from the bond market is simplistic,” he stated.
An inverted curve does not have a single, universally accepted definition. Investors in the financial district of New York City, known as Wall Street, typically prioritize the 2-year Treasury note and the 10-year note due to their high trading frequency. Certain economists have a preference for comparing the 10-year yield with either the 3-month or 1-year yield.
Another consideration is determining the appropriate timing to initiate a recession monitoring process. Should it commence when a segment of the yield curve experiences a temporary inversion, or should it be based on a sustained inversion?
According to various indicators, the current period of waiting for an economic slump is already approaching or exceeding any period experienced in recent history.
Historically, it has taken anywhere from nine to 24 months for a recession to occur after the beginning of an inversion, where the 10-year yield drops below the 1-year yield for at least one month, starting from 1968.
According to that criteria, the most recent inversion is about to conclude its 23rd month. However, after the beginning of the inversion until April, the economy has experienced a significant increase in job creation compared to any similar time that occurred after an inversion. There is scant evidence to suggest that the inversion will cease in the near future.
Historically, inversions have frequently occurred just prior to recessions, coinciding with the anticipation of interest rate reductions by the Federal Reserve. This has resulted in a significant decrease in short-term Treasury yields.
Several recent economic statistics have not met the anticipated level of strength. However, investors are unlikely to have confidence in the yield curve un-inverting, considering the significant losses incurred in the past year and a half, as stated by Michael Lorizio, a senior fixed-income trader at Manulife Investment Management.
“The occurrence of curve inversion, particularly in the early stages of the cycle, significantly influenced the mindset of investors,” he stated. “However, I believe that this has now become the prevailing standard.”
