Dont panic about the inverted yield curve

Last week the 10-year yield declined below the Federal Funds target rate. I discussed this risk last October but now it has happened, lets review what it might mean. A recession always follows, right?

Well, not necessarily. In June 1998 the yield curve went negative and stayed there (mostly) for about 6 months but then turned positive again. Recession was still 3 years away. And it nearly went negative in 1995 after the Fed raised rates sharply and the economy slowed for a time. But again, it did not signal a recession.

Even if a recession does soon follow it will not be immediate. On past form it takes 10-19 months which would point to a recession in 2020 (see table below). In the 2000s upswing the spread hit zero in March 2006, then lifted above for a couple of months before going through zero again in June 2006 and heading further south after that. The June inversion was 19 months before the recession started in January 2008. Going further back the yield curve inverted 10 months before the 2001 recession and 17 months before the 1990 recession.

This time the 10 year yield is being held down by special factors which makes the signal especially suspect. One factor is the very low yields in safe European assets. 10-year Bund yields have plunged from about 0.5% last October to just below zero today on economic weakness in Europe. Another is the continued search for safe assets by long term pension and insurance managers as well as banks, driven by regulations.

More broadly, the fear now is that the US economy is going to be dragged into recession by economic weakness in China and Europe. If that happens it will be a first and will mark the end of the dominance of the US cycle in the world economy. US cycles have been ended by externally-driven oil price shocks before, though even in these cases it was the Fed’s tightening response that was decisive. But they havent been determined by other countries' cycles since at least the 1920s. So what the markets are worrying about today is the end of a century of US economic dominance. If and when the US is usurped it will be by China but I dont think we are there yet. Maybe in a couple of decades if China continues to grow strongly (which I don’t actually expect).

Meanwhile I don’t believe the Fed has over-tightened. The current level of the Federal Funds rate (at 2.5%) looks much less restrictive than when the yield curve inverted before. Approaching the last three recessions the real Fed funds rate at the point of yield curve inversion was 5% in 1989, 4.3% in 2000 and 2.5% in 2006. (I am using the core consumer expenditure deflator here.) Surely in 1989 and again in 2000 we would agree that policy was tight at this point, so a recession following was not too surprising. In 2006 real rates went on up to just above 3% on this measure, which at the time was not seen as far above ‘neutral’ but, some argue in fact was, as evidenced by the subsequent recession. This time, the real Federal Funds rate is only 0.7%, with core inflation at 1.8%.

Overall then, the risk of the next recession starting in 2020 has risen, but I still think it is more likely to come in 2021 or 2022 and be the result of higher US inflation leading to a new Fed tightening cycle. Usually recessions involve some sort of shock in addition to a weak economy so that is always a risk.

But I hold to my view that world economic activity will in fact pick up later this year, led by China, so that fears of a world downturn recede. If that is right, then the Fed may well gradually turn back to a tightening bias, though I believe it will be very cautious. Indeed, it will wait until inflation moves noticeably above 2% which could take a while. I think inflation will rise, at some point, but the Phillips Curve is definitely flatter than it used to be so the response is likely to be slow. Moreover, as I have said elsewhere, the Fed is minded to tolerate a bit of inflation overshoot given that inflation has been below 2% for almost all of the last 10 years.

Suppose I am wrong and there is a recession coming next year. Does that mean sell stocks now? Actually no, as the table above shows. In 1989 and in 2006 when the curve inverted and a recession did follow, there was a 23% or more gain still to be had over the ensuing 18 months or so. This is NOT investment advice but it is a reminder that the market usually does rise even near the end of the Late Upswing.