A worrying yield curve: Is a recession on the horizon for the US economy?

About a year ago, the yield curve for US Treasurys experienced an inversion, meaning that short-term bonds offered higher interest rates than their long-term counterparts. Recently, the gap between two specific bonds reached its widest point since 1981, further deepening this inversion.

The yield curve, which had already been inverted, has become even more pronounced in its divergence between short-term and long-term bond yields. The yield curve usually doesn’t capture the everyday investor’s close attention, but it holds significant significance for financial experts. 

A sure sign of recession?

Yields on short-term bonds are tied to the interest rate determined by the Fed. Over the past year and a bit, the central bank implemented a series of increases to its benchmark interest rate in an attempt to combat surging inflation. This rate has increased from nearly zero to 5% to 5.5%.

In the meantime, some investors have become apprehensive about the economy, fearing that the Fed’s aggressive rate hike approach could potentially slow the economy to the extent that it taps into a recession.

As Sam Stovall, Chief Investment Strategist at CFRA, points out, government bonds have historically served as a safe haven in such situations. He notes that while the US government remains stable, some companies may face difficulties, even those generally considered stable, especially during recessionary periods.

As investors flock to long-term government bonds, they drive up the prices of these investments. Since bond prices and interest rates move in opposite directions, long-term Treasurys have experienced a decline in yield.

For decades, “inversions” in the yield curve, which refer to differences in yields of the US Treasuries with varying maturities, have been seen as reliable indicators of impending recessions. However, this time, they have proven to be notably unreliable. Closer examination reveals several weaknesses in their historical accuracy.

An inverted yield curve often leads to unprofitable bank calculations in many cases. That makes them more hesitant to lend to businesses, which in turn find expanding more challenging, consequently slowing down the economy.

Based on an analysis by Horneman going back to 1978, it typically takes around 15 months on average for the economy to enter a recession after the yield curve inverts. Applying this timeframe to the current inversion which occurred roughly a year ago), the economy could potentially enter a recession in October of this year.

Nonetheless, it’s important to remember that past performance does not guarantee future results. Moreover, even historical performance can sometimes be somewhat misleading. The last time the yield curve inverted was in 2019, and although a brief recession did follow, other major economic factors were at play at the time.

Furthermore, while some indicators signal potential recession risks for investors, others indicate a healthy economic outlook. As evidence, the stock market has seen a robust 16% increase this year, hardly indicative of a pessimistic market sentiment.

Prior predictions pointed towards recession in 2023

Goldman Sachs has recently revised its projection of the likelihood of the US entering a recession within the next 12 months to just 15%, a significant decrease from their earlier estimate of 35% in March.

This adjustment raises the question of whether the bond market’s signals are accurate. For over a year, there has been an inverted yield curve, indicating that the interest paid on 10-year Treasury bonds has been lower than that on shorter-term debt, such as two-year US Treasurys.

Although parts of the yield curve started inverting as early as July 2022, the economy continues to show resilience. According to Menzie Chinn, a professor at the University of Wisconsin-Madison, it is premature to label the bond market as misleading. He notes that the time lag between the inversion and the onset of a recession can vary widely, ranging from six to eight months to 18 months.

Scott Ladner with Horizon Investments proposes another possibility—that this economy has evolved differently after three years of the pandemic. He points out that the nation entered this period from a position of strength, with companies and individuals in a relatively robust financial position compared to previous decades. In his view, a close examination of the yield curve doesn’t necessarily predict a recession but indicates an adjustment by the Federal Reserve to bring inflation back to normal.

Goldman’s recent adjustment of its recession prediction reflects a relatively bullish perspective compared to the broader market landscape. They now suggest that the Fed may have effectively addressed inflation concerns and avoided an imminent economic slowdown.

US economy has avoided a terrible fate

Around this time last year, economist Nouriel Roubini, known as “Dr. Doom” for his consistently pessimistic market outlook, warned of what he believed to be an almost impossible challenge for the US – avoiding a severe recession in 2023. 

At that time, the CEO of Roubini Macro Associates expressed concern that the Federal Reserve’s aggressive interest rate hikes, in its effort to curb inflation reaching a four-decade high of over 9% in June 2022, could potentially bring the American economy to a grinding halt. He pointed to record-high global private and public debts, coupled with the escalating economic costs of the conflict in Ukraine. He forecasted a scenario he termed a “stagflationary debt crisis,” or even a variant of another “Great Depression.”

However, Roubini’s perspective has since shifted. He now believes that the US economy may have sidestepped these dire scenarios, at least for now. He recently stated that the good news is it doesn’t look like we will have a real hard landing, using the aviation analogy favored by economists to describe a recession. He added that the question is whether we will have a soft landing or a bumpy landing—a bumpy landing being a short and shallow recession—and we don’t know yet on that debate.

That marks a significant change in Roubini’s stance, considering that in July 2022, he dismissed his peers’ predictions of a short and shallow recession as “totally delusional.” A lot has changed since then. Fed Chair Jerome Powell brought down inflation from its pandemic-era peak of 9.1% to just 3.7% while sustaining US GDP growth. Supply chains, which were disrupted during the pandemic, have largely recovered. And despite a brief regional banking crisis in March, the S&P 500 has seen an increase of over 16% year-to-date.

While the positive developments have led Roubini to adopt a somewhat more optimistic outlook on the near-term prospects of the US economy, he still harbors concerns about the possibility of a mild recession. Notably, he views “sticky” inflation as the most substantial economic risk. Roubini highlighted that in 2023, oil prices, a significant factor in the inflation surge during the pandemic, have surged due to supply cuts from OPEC and Russia. West Texas Intermediate crude prices in the US have risen by approximately 20% this year, reaching over $91 per barrel. According to Roubini, higher oil prices imply higher inflation and lower economic activity.

While inflation has considerably decreased from its four-decade high, it remains well above the Fed’s 2% target. That could potentially lead the central bank to implement further interest rate hikes. Roubini fears that additional tightening by the Fed could trigger a mild recession.