Wall Street’s Favorite Recession Signal Is Flashing Red — But No Recession Has Arrived
The inverted yield curve, a time-tested indicator of upcoming recessions, has been flashing red for over a year. However, despite its historical accuracy, the U.S. economy has so far defied the forecast, showing no signs of a downturn. This unusual situation has left economists and investors questioning the reliability of this once-infallible predictor.
Key Takeaways:
- The yield curve has been inverted since July 2022, a period where it has consistently signaled an impending recession.
- Historically, a recession has followed within a year or two after an inverted yield curve, making this current situation unprecedented.
- The inverted yield curve, however, has not been the only indicator suggesting economic headwinds. The Sahm Rule and the Conference Board’s leading economic indicators are also flashing warning signs.
- Economists are attributing the lack of a recession to the unusual behavior of the Federal Reserve which raised rates aggressively after inflation peaked, in contrast to its historical practice of raising rates early in the inflation cycle.
- Companies have benefitted from the low long-term rates locked in before the Fed’s rate hikes, providing a buffer against higher short-term rates. However, as these loans mature, companies may face a much harder time rolling over debt if high rates persist.
The Inversion Is Not Alone
The inverted yield curve is not the only cause for concern within the U.S. economy. Other indicators suggest that the economic recovery post-Covid might not last much longer. The gross domestic product (GDP), while relatively strong in recent quarters, has been showing some negative trends.
Several indicators are pointing towards potential economic headwinds:
- The Sahm Rule, a recession gauge, is nearing the threshold for triggering a recession.
- The money supply has been declining since its peak in April 2022.
- The Conference Board’s index of leading economic indicators has been consistently negative, suggesting significant obstacles to future growth.
While these indicators point towards potential recession, the economy has yet to show signs of faltering.
What’s Different This Time?
This atypical behavior has sparked debate among economists. Many believe that the inverted yield curve has been wrong in this instance due to the unusual actions of the Federal Reserve. By increasing interest rates rapidly after inflation reached its peak, the Fed has acted counter to its historical approach.
This shift in strategy has benefitted companies, allowing them to secure low long-term rates, providing a buffer from higher short-term costs. However, the risk remains that as these loans come due, companies may struggle to refinance at current high interest rates, potentially triggering a self-fulfilling prophecy for the inverted yield curve.
The Future of the Yield Curve
The inverted yield curve is a powerful indicator, but its unprecedented failure this time has resulted in a debate about its reliability.
Economists acknowledge its long history of accurately predicting recessions and remain cautious, even in the face of current economic resilience. They emphasize that it is still a cause for concern, particularly with the looming threat of high interest rates impacting the economy’s ability to sustain its growth.
According to Mark Zandi, chief economist at Moody’s Analytics, "It makes me really uncomfortable that the curve is inverted. This is one more reason why the Fed should be lowering interest rates. They’re taking a chance here."
While the U.S. economy has demonstrated surprising resilience, the question remains: will the inverted yield curve finally prove prophetic, or has it fundamentally lost its predictive power? Only time will tell.
