US recession indicator ‘not flashing code red yet’, pioneer yield curve researcher says
Amid debate over whether the United States is on the verge of an economic downturn, the Duke University finance professor who pioneered the use of bond market yield curves as a tool predictive, has a few things to say.
The first is that it’s too early to tell if a contraction is on the way, even though the world’s largest economy appears poised for a slowdown, according to Campbell Harvey, whose 1986 dissertation at the University of Chicago determined that the difference between long- and short-term interest rates was related to future economic growth in the United States. Additionally, he says, the recent brief reversal in the 2-year and 10-year Treasury spread must persist for three months to provide a meaningful signal.
“Everything points to a slowdown in economic growth,” said Harvey, a 63-year-old Canadian-born economist. Referring to the narrowing of spreads between long and short rates seen in various parts of the US Treasury market in recent months, he says that “any flattening is likely associated with slower US economic growth. And it’s reasonable to expect flattening across the curve, given that the Fed is in a tightening cycle.
“When it comes to the slope of the yield curve, flat is bad and inverted is really bad,” he told MarketWatch in a phone interview Thursday. “And right now the yield curve is not flashing code red for a recession.”
Typically, in a healthy economy, yield spreads widen as investors bank on brighter long-term growth prospects, causing the Treasury curve to slope upwards. Conversely, spreads flatten when the outlook is more pessimistic, and may even fall below zero and reverse.
Historically speaking, yield spreads generally do not approach zero until interest rate hikes by the Federal Reserve are well underway. This time around, however, a handful of spreads are being reversed while others are teetering on the brink at a time when the Fed has only hiked its key interest rate by a quarter of a percentage point from benchmark, although policymakers are poised to make further hikes.
In particular, the widely followed spread between 2-TMUBMUSD02Y,
and the 10-year Treasury yields TMUBMUSD10Y,
flattened at a faster rate than at any time since the 1980s, even before the Fed’s March 16 quarter-point hike. It dipped below zero on March 29 and remained inverted for just a few days, sparking debate over its usefulness as a recession signal. It was the first reversal in the spread since August 30, 2019, which preceded a two-month slowdown in 2020 due to the pandemic.
Gargi Chaudhuri, Head of iShares Investment Strategy for the Americas at BlackRock Inc. BLK,
said in a note on Friday: “We don’t see a recession happening in the near term.” His remarks came a day after St. Louis Fed policymaker James Bullard said officials could raise interest rates significantly without hurting the economy. Former U.S. Treasury Secretary Lawrence Summers, meanwhile, told Bloomberg Television he expected economists to come around to a consensus view that a U.S. recession over the next two years “is clearly more likely than not.”
Economic downturns tend to follow a 2s/10s reversal in returns with a lag of around 20 months, and in some cases more than two years. Such an inversion can also impact the psychology of businesses, making them more reluctant to spend.
But there is an extremely important caveat, Duke’s Harvey said: “A reversal has to last a quarter – a day or a week just doesn’t make sense – and it didn’t happen.” He attributed the speed of the flattening of the 2s/10s since November to “a miscalibration of people’s inflation expectations”, and not necessarily a sign that a deeper reversal is underway.
Like Fed Chairman Jerome Powell, Harvey pointed to the shorter end of the Treasury market – the bond sector – as the starting point for a more relevant indication of where the Treasury might be headed. the economy. The difference between the rates on the three-month invoice TMUBMUSD03M,
and the 10-year note is still above 200 basis points, suggesting to some that economic growth may continue. Like its 2s/10s counterpart, the 3m/10y spread also reversed in 2019, before the February-April 2020 recession.
Even though the 3-month/10-year gap is sloping positive, “it is reasonable to suspect that there will be substantial flattening over the next year,” Harvey said.
“The economic theory is clear: what you care about is where the growth will be, from now on,” he said. “And for that, you need to anchor it to short-term yield. Given the Fed’s rate hike expectations, it’s reasonable to think that the 3-month rate is up.
The 3-month bill, which now hovers around 0.68%, only reflects the Fed hikes that have actually been made – while the 2-year rate, at around 2.5%, reflects expectations for the future rate hikes. Many observers say the central bank is now well behind the curve when it comes to fighting inflation.
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The complication of the economic outlook is an issue that hasn’t received as much attention as the yield curve, inflation, or the prospect of further Fed rate hikes: the federal debt-to-GDP ratio, which was greater than 100% at the end of last year.
When interest rates rise, US debt service payments also rise, which, in turn, will increase the size of the government’s budget deficit, according to Harvey. “The Fed will have to take this into account. What is the implication if we push rates up? Ultimately, the Fed’s goal is to get inflation under control without hurting jobs—a soft landing. This task is very complicated and the fact that the debt to GDP ratio is so high makes it a much more difficult problem.
Treasuries sold across the board on Friday, pushing the 10-year yield above 2.7%. The 2s/10s spread flipped between steepening and flattening during the day as investors continued to assess the Fed’s most likely policy path. Meanwhile, major stock indexes were mixed, with Dow Jones Industrial Average DJIA,
up more than 180 points, or 0.5%, at the end of the afternoon and on the S&P 500 SPX,
and Nasdaq Composite COMP,