Recession Watch

What an inverted yield curve could mean for the next 12-18 months

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This past week two key data points suggested the exact opposite likelihood of a pending recession, which speaks to both the economic uncertainty of the current moment and the vast array of publicly available data, which economists and media commentators can cherrypick however they would like to push a narrative of their choosing.

So what’s the true story of the current economy? Well, on the positive side of things, the Bureau of Labor Statistics released its monthly jobs report on Friday, noting:

Total nonfarm payroll employment rose by 431,000 in March, and the unemployment rate declined to 3.6 percent…notable job gains continued in leisure and hospitality, professional and business services, retail trade, and manufacturing.

The 3.6% unemployment rate was better than the 3.7% that had been predicted by a survey of economists before the report was published, and is the lowest it has been since a 3.5% reading in February 2020 (we all know what happened next).

Ten-year history of the U.S. unemployment rate. Source: BLS

The low unemployment rate is, of course, a strong indicator for the U.S. economy because people who are working are more likely to feel secure and have money to spend, sending positive ripple effects through the economy. The fact that workers are in such high demand shows that businesses are generally doing well and are willing and able to hire. Friday’s report on the heels of similarly positive reports in February and March led Bloomberg columnist Connor Sen to succinctly tweet the following:

Conor Sen @conorsen

1.7 million jobs created in Q1. We're not in a recession.

On the other hand, there are plenty of data points to suggest things are headed in the opposite direction. Inflation is running at its hottest levels in 40 years, gas and energy prices have spiked, supply chain challenges still abound, the war in Ukraine has cast a shadow of uncertainty over everything, and oh by the way, stock markets around the world including here in the United States dropped 10-20% in the early weeks of 2022 (although stocks have since clawed back some, though not all, of those losses). On that latter point, Lu Wang and Isabelle Lee noted this past week in Bloomberg:

War, inflation and the lingering impact of a global disease made the first quarter a historically rough one for stock and bond investors.

Across equity and fixed-income markets broadly, the least-bad performance among U.S. assets were declines of 4.9% in the S&P 500 and speculative credit. They were followed by a 5.6% fall in Treasuries and a 7.8% slide in investment grade. Not since 1980 has the best return among those four categories been so paltry.

In other words, if you were actively invested in the first quarter of 2022, losing 5% was probably the best you could do short of hitting it lucky on various individual stocks or being overweight in certain sectors (energy stocks, in particular, have been the leaders for the year so far).

The Yield Curve

Another interesting thing happened on Friday: the yield on the 10-year U.S. Treasury Bond ended the day at 2.38% and the yield on the 2-year U.S. Treasury ended the day at 2.44%. Typically investors require a greater rate of return in order to lock up their money for a longer term, so the inverted yield curve, as it is called, is noteworthy. In a nutshell, the fact that the yield curve is inverted shows that market participants and other investors are expecting increases in interest rates in the short term, but over the long-term they are less certain that rates will continue to rise, which could be due to an economic slowdown, a leveling off of inflationary pressures, or both. And in fact, this specific inversion (the 2-year over the 10-year) has commonly preceded U.S. economic recessions. Per Reuters:

The U.S. curve has inverted before each recession since 1955, with a recession following between six and 24 months, according to a 2018 report by researchers at the Federal Reserve Bank of San Francisco. It offered a false signal just once in that time.

According to Anu Gaggar, Global Investment Strategist for Commonwealth Financial Network, who looked at the 2/10 part of the curve, there have been 28 instances since 1900 where the yield curve has inverted; in 22 of these episodes, a recession has followed. The lag between curve inversion and the start of a recession has averaged about 22 months but has ranged from 6 to 36 months for the last six recessions, she wrote.

Interestingly enough, the Federal Reserve itself has an article posted on its website (complete with Blue Oyster Cult/More Cowbell references), advising people not to read too much into the current inversion. In fact, the authors note that the inversion itself is not causal; it is that so many people believe the inversion inevitably leads to recessions that market participants then collectively react in ways that actually push the economy towards recession. “Don’t fear the inversion,” they note, even going so far as to reference President Franklin D. Roosevelt’s “the only thing we have to fear is fear itself” speech:

As FDR might have pointed out, it can only make things worse if investors not only fear the prospect of a recession, but at the same time, are spooked by that fear itself, which is mirrored in inverted term spreads.

Lastly, without belaboring the yield curve discussion any further, some commentators including those same researchers from the Federal Reserve are currently pointing to the relationship between the three-month U.S. Treasury Bill and the 10-Year, which has not inverted and, in fact, has shown a modestly widening gap between the two yields, as the more accurate accurate predictor of the current moment. There are a lot of technical reasons why the 2/10 year gap may have inverted at this specific moment in time that do not technically portend a recession, some are saying.

What I Think

Based on my research and analysis and just my own gut-level opinion based on following this stuff day-in-and-day out, I think it is likely that the U.S. economy is headed for a modest recession 8-12 months from now. However, I do not necessarily think this should be overly alarming. We are overdue for a pullback in both economic conditions and asset inflation. A pullback can be healthy in some ways (although, to be sure, that depends a lot on your perspective and objectives; the cost of borrowing going up is decidedly not good for many Americans of all backgrounds and income levels). But a cooling off is not necessarily all bad, especially if the economy can stabilize as a result of that cooling off and then gain positive traction going forward once again.

One reason I believe this is that the Federal Reserve has not shown that it has a sound understanding of inflation. So what evidence is there to believe that they will handle inflation properly going forward? Fed Chair Jerome Powell held onto the term “transitory” for far too long in describing inflationary pressures last year. Now, upon realizing that inflation has been much more robust and sticky, the Fed has signaled that it will not hesitate to drop the hammer by raising rates six or seven more times in 2022, and possibly by as much as 50 basis points (0.50%) at least once or twice. With employment being as strong as it is, evidenced first and foremost by the 3.6% unemployment figure from Friday’s jobs report, the Fed can focus almost entirely on controlling inflation. The tool they have to do that is to raise interest rates, but in doing so they risk cooling things off too hard, too fast, and sending the U.S. economy into a recession. I think this is the most likely scenario. However, given the strong workforce numbers and the fact that Americans’ savings and investment levels have been stronger over the past two years (thanks in large part to various stimulus programs), there are plenty of reasons to be optimistic that the U.S. consumer will be able to withstand a mild recession and U.S. household balance sheets will hold up long enough for the lingering economic “weirdness” from the COVID-19 pandemic to settle out and we can hopefully achieve that Goldilocks not-too-hot, not-too-cold equilibrium. Time will tell.

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Ben Sprague lives and works in Bangor, Maine as a V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com. Follow Ben on Twitter, Facebook, or Instagram and subscribe to this weekly newsletter by clicking below.

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No Weekly Round-Up this week as I just got back from a week’s vacation in Florida with my family. I’ll be back next week with another article and some links. Have a great week, everybody.