Roaring Twenties Morphs Into Whimper

The more things change, the more they stay the same (or for purists, plus ça change, plus c’est la même chose). No matter how smart any prognosticator thinks she is in the moment, heralding a “this time is different” narrative, the real world reminds us that human beings are hardwired to allow the recent past to inform what we believe will be the future. Just over a year ago, hopes were high for a post-pandemic surge in activity, encouraging economists and bullish investors to wager that the U.S. economy 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 a 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 percent annual pace in the first quarter and as the Federal Reserve gears up for a two-day policy meeting, the question is ever-more important.

Despite the pokey start to the year, the Fed is still expected to raise short term interest rates by 0.50 percent to fight 40-year highs in inflation. The central bank’s campaign to increase rates has also spawned heightened conversations about yield curve inversions, the unusual market condition when it costs more to borrow for the government in the short term than the longer term.

Typically, it should cost less to borrow for shorter periods of time than longer ones. In the case of government bonds, when you buy a ten-year, the interest rate is normally higher than when you buy a two-year (the difference between those two interest rates is known as the “spread”). The reason is that lots of things can happen in the future, so bond buyers usually demand higher interest rates to compensate them for the additional risk of lending the money for a longer term.

When plotting government yields on a chart, a normal period slopes upwards, the steeper the slope, the more that investors think that growth, inflation, and interest rates will be increasing in the future. When investors believe that the economy is slowing and that the rate of inflation will be tepid in the future, the yield curve flattens.

When short-term interest rates are higher than long-term rates, the yield curve inverts, meaning that it slopes downward. Shearing notes “There is no mechanical link between an inverted curve and the real economy,” but its significance reflects “the collective wisdom of deep and liquid bond markets.” The current inversion could mean 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, wagering that the Fed will raise rates for the next couple of years and then will be forced to do a 180, after the economy enters a recession. In other words, market timing on steroids.

Historically when the relationship between two-and ten-year government bonds inverts and stays that way for three to six months, it can be bad news for the economy and 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 recession calls. For example, the curve inverted in 2019, but it would seem far-fetched to attach the outcome of a once-in-century pandemic-induced recession to that inversion. What’s more likely is that in 2019, bond investors got a little spooked about the future. Had the two-month COVID recession not occurred, it’s likely that we would have used the 2019 inversion as proof that the old inversion/recession link was broken.

Shearing says that the current yield curve “has been distorted by the effects of large-scale central bank asset purchases over the past decade”, [Quantitative Easing or bond buying] which may mean that this time really is different and that the inverted yield curve “may have lost some of its predictive power.”  This inversion perversion underscores just how spooked we are about recessions in general. While nobody wants to see a return to high unemployment and human suffering, unfortunately, recessions are natural occurrences of the economic cycle. Sometimes the contraction and subsequent recovery last a long time (the Great Recession) and sometimes the damage is deep, but the length is short (the COVID Recession).

To get an idea of whether a recession is coming any time soon, it’s instructive to go to the source, the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER). The Committee does not have a fixed definition of recessions; rather it examines and compares the behavior of various measures of broad activity: real economic growth and income (both adjusted for inflation), employment, industrial production, and wholesale-retail sales. While most of these metrics are holding up, high inflation and rising interest rates will curtail spending, especially as consumers drain their pandemic-era savings (the personal saving rate dropped to 6.2 percent in March and hit the lowest level since 2013 in Q1).

A drop in both personal and business spending means that the economy will cool considerably from last year’s 5.7 percent annualized growth rate, but it’s hard to know whether it will slow enough to trigger a recession. “The challenge will be for the Fed to cool domestic demand without sending too much of a chill through the labor market,” says Grant Thornton Chief Economist Diane Swonk. “Getting policy “just right” is no easy feat. Goldilocks only exists in fairy tales.”