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Jill On Money: Can curves predict recessions?

Jill Schlesinger on

Over a year ago, hopes were high for a post-pandemic surge in activity, encouraging economists and optimistic investors to wager that the U.S. was entering a NEW Roaring Twenties.

“What a difference a year makes,” says Neil Shearing of Capital Economics. “The narrative has now flipped as concerns about recession have spread,” prompting Shearing to ponder: “Is this latest story any more convincing than last year’s?”

Given that the U.S. economy contracted at a 1.4% annual pace in the first quarter and as the Federal Reserve continues its inflation-fighting rate hike strategy, there have been heightened concerns about a potential recession and how the relationships between bonds are predicting just that outcome.

A yield curve inversion is the unusual market condition when it costs more to borrow in the short term than the longer term.

Typically, it should be cheaper to borrow for shorter periods than longer ones, because lots of things can happen in the future. That’s why bond buyers (lenders) usually demand higher rates to compensate for the additional risk of longer terms. So, in most cases when you buy a 10-year bond, the interest rate is higher than when you buy a two-year one.

But when short-term interest rates are higher than long-term rates, the yield curve inverts – meaning that it slopes downward, which is what has recently occurred.

 

Tea-leaf readers think that the inversion means that investors are worried that the Fed will not be able to thread the needle of increasing rates without throwing the economy into a recession. So, they dump short-dated government bonds and load up on the longer-dated ones. The thinking is that the Fed will raise rates for the next couple of years and then will be forced to do a 180, after the economy slows.

Historically when the relationship between two- and ten-year government bonds inverts and stays that way for three to six months, it can presage a recession.

Shearing points out that “the curve has inverted ahead of every recession in the U.S. over the past 50 years, with only one false positive (in 1998). It’s therefore about as good a recession indicator as we’re going to get. Ignoring the yield curve means betting against history.”

But inversions may not always be the Magic 8-Ball, when it comes to recessions.

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