More than a year ago, hopes were high for a jump in activity after a pandemic, encouraging economists and optimistic investors to bet that the United States is entering a NEW turbulent twenties.
“What a difference a year makes,” said Neil Shearing of Capital Economics. The story has now turned, as fears of a recession have spread, Shearing thought, “Is this latest story more convincing than last year?”
As the US economy contracted at a 1.4% annual rate in the first quarter, and as the Federal Reserve continues its strategy to raise inflation, there are growing concerns about a potential recession and how bond linkages predict just that.
The inversion of the yield curve is an unusual market situation where borrowing costs more in the short term than in the long term.
It should usually be cheaper to borrow for shorter periods than longer ones, because many things can happen in the future. Therefore, bond buyers (creditors) usually require higher interest rates to offset the additional risk of longer maturities. So in most cases, when you buy a 10-year bond, the interest rate is higher than when you buy a two-year bond.
But when short-term interest rates are higher than long-term ones, the yield curve reverses – meaning it is going down, which happened recently.
Readers of Tea Leaf believe that the inversion means that investors are worried that the Fed will not be able to push the needle of raising interest rates without throwing the economy into recession. Thus, they discard short-term government bonds and refuel with longer-term ones. The Fed is expected to raise interest rates for the next few years and then be forced to make 180 after the economy slows.
Historically, when the relationship between two- and ten-year government bonds is reversed and remains so for three to six months, it could portend a recession.
Shearing points out that the curve has reversed before any recession in the United States in the last 50 years, with only one false positive (1998). Therefore, this is as good an indicator of a recession as we will get. Ignoring the yield curve means betting on history. “
But inversions may not always be Magic 8-Ball when it comes to recessions.
For example, the curve was reversed in 2019, but it would seem exaggerated to link the result of a recession caused by a pandemic once a century to this inversion.
It is more likely that in 2019 bond investors are a little scared for the future. If the two-month COVID recession does not occur, we may have used 2019 as evidence that the inversion / recession relationship has been broken.
In addition, the Fed’s major bond-buying campaigns over the past decade may distort the yield curve, meaning that the inversion “may have lost some of its projected strength,” says Shearing.
But this perversion of inversion underscores how scared we are of recessions in general. Although no one wants to see a return to high unemployment and human suffering, recessions are a natural phenomenon of the economic cycle. Sometimes the contraction and subsequent recovery lasts a long time (the Great Recession), and sometimes the damage is deep, but the duration is short (the COVID Recession).
For now, there are signs of a slowdown as high inflation and rising interest rates eat away at corporate profits and personal spending, putting inversion advocates and Fed observers on high alert.
“The challenge will be for the Fed to cool domestic demand without causing too much cold in the job market,” said Diane Swank, chief economist at Grant Thornton. “Getting a policy” exactly “is not an easy task. Goldilocks exists only in fairy tales. “
Jill Schlesinger, CFP, is a business analyst at CBS News. A former options trader and CIO of an investment consulting firm, she welcomes comments and questions to askjill@jillonmoney.com. Check out her website at www.jillonmoney.com.
