The yield curve and recessions

There are understandable concerns about the high and persistent inflation rates around the globe. Much of this is to do with the spike in energy costs, but also in other commodities. Partly this is due to supply issues and increased demand as the economy bounced back from the pandemic, but there’s also the war in Ukraine to consider as well. High energy prices are proving to be quite persistent, and central bankers have been very slow and reluctant to raise interest rates in response. Their fear has been that the global economy is far from robust. But high and persistent inflation is forcing central banks, led by the US Federal Reserve, to tighten monetary policy aggressively just as global economic growth is faltering. This is causing great concern and adding to fears that the US and other countries could be heading for a recession. 

Recession

Stock markets don’t like recessions. Rising prices lead to a decline in consumer demand as workers struggle to pay their bills and cut back on their spending. This is exacerbated as companies are forced to make redundancies and the newly unemployed must rely on savings and government benefits. But recessions can be short and sharp, or long and drawn out. We had a short and sharp recession in early 2020 due to the coronavirus pandemic, while the recession we saw during the Great Financial Crisis of 2008/9 was relatively drawn out. But in both cases central banks and governments helped stave off the worst effects by injecting huge dollops of monetary and fiscal stimuli into the global economy. That was seen by most people as right and proper during the pandemic. After all, it was policymakers who were responsible for ordering lockdowns and the subsequent closing of many businesses. But it can be reasonably argued that much of the financial help that was doled out during 2008/9 went to the people and businesses that were responsible for the crash in the first place. This should be borne in mind when the next recession comes, because they do come around quite often. In my lifetime they have cropped up in the early 1990s, 1980s and mid-1970s.

Yield curves

About a month ago we saw an inversion in parts of the US yield curve. This is where the yields on shorter duration Treasuries pushed above those on some of the longer ones.  In this case, the yield on the 2-year US Treasury exceeded that of the 10-year. An inverted yield curve means something is wrong in the economy. Yields are supposed to reflect risk, and risk grows with time. The chance something bad will happen in the next 10 years is higher than the chance something equally bad will happen in the next two years. Consequently, longer-term bond investors require higher yields as compensation for that higher risk. So, what does inversion tell us? In specific cases, an inversion can be a reliable indicator that a recession will follow in 18-24 months’ time. The thinking goes that central banks will have to push up interest rates (yields) now to dampen inflation. But this will cause future economic growth to fall to such an extent that they will have to slash rates later to compensate. There’s no doubt that yield curve inversion does precede recessions. But recessions don’t always follow from yield curve inversion. The inversion must be deep and last for a significant period. The longer the inversion, the stronger its predictive value. All the recent inversions we saw reversed out again after a few days. In addition, the most reliable recession indicator is an inversion of the 3-month yield against the 10-year. We haven’t seen that happen yet - not even close. 

Federal Reserve 

But we all know that the US Federal Reserve has been keeping a lid on its Fed Funds rate, the shortest-term US interest rate. In March, the Fed raised it to just under 50 basis points (bps) from 25 bps. With the 10-year currently well under 300 bps, there’s a big gap to be filled, even though the 3-month is presently above the fed funds rate. But recent speculation over how aggressive the US central bank may be in raising rates to try and cap inflation has raised serious concerns. For instance, the Fed is now expected to raise rates by 50 bps in early May. On top of this and following Fed Chair Jerome Powell’s comments about ‘front loading’ rate hikes, some analysts reckon the Fed could then hike rates by 75 bps in both June and July. If so, that would put the fed funds rate at just under 2.50% or 250 bps. The current 10-year yield is 276 bps. That’s getting perilously close to inverting. all other things being equal. But such a move from the Fed would be very aggressive. It would mean that the Federal Reserve has taken rates from under 0.25% to 2.50% in just four months. The last time it was raising rates it took three years (December 2015 – December 2018) to achieve the same result. 

Soft landing

But the Fed are hoping that they can engineer a soft landing. They will hope that a few rate hikes over the coming months could coincide with a peak in inflation. Add in the fact that unemployment is back to historically low levels, that the current evidence from the Q1 earnings season is that companies are beating expectations and are generally upbeat, and perhaps economic growth is not about to stagnate. But we must be prepared. Central banks are all treading a fine line and can make mistakes. History is littered with them. We could easily experience a stock market slump and recession within the next five years. But if policymakers and central bankers intervene again, any recession may hopefully be short and sharp. The big danger comes from a longer lasting recession. In that situation the only thing to try and do is future-proof your employment prospects. Maybe it’s a good time to learn a few new skills.