Why There Is Too Much Emphasis on Recession and the Inverted Yield Curve in 2019

April 15, 2019 by Jon C. Ogg

Get ready, because the recession is coming. The only problem is that the “when that will be” probably is not as soon as many financial media reports might have you scared about. There is a misconception out there after the U.S. Treasury’s yield curve recently inverted, meaning long-term interest rates are lower than some short-term and intermediate-term rates, that means the next recession is around the corner.

Many undecided factors with unknown outcomes are going to have to play themselves out for the next formal recession to arrive. We can argue all day long about the socialist movement in America being economically damaging, or we can argue about the ongoing “soon to be, but as of yet unresolved” trade spat with China or about slower global growth rates and even Brexit for some international watchers at a more granular level. Until some more time plays out, and until the actual result of the outcome is seen, the reality is that it’s just too soon to jump the gun with formal recession timing as being imminent.

The next recession’s timing because of the current yield curve simply isn’t giving the same message as in many past instances. The 2019 inversion has been a “barely inverted” curve. Not all long-term rates went under short-term and intermediate-term ones, and those that did simply did not do it very much. There is also a backdrop in which rates in Europe and Japan are very positive again, which was not really the case in decades past.

The financial media also may have played a role in just how much this inverted yield curve really means in the big picture. The inverted yield curves of years past also came at significantly higher rates than today (I was selling CDs with close to 10% yields about 30 years ago). The St. Louis Fed also gets more specific about when an inversion really is: 10-year rates being negative by greater than 0.25% compared with the one-year Treasury. It also defines negative housing starts in the mix, with a decline of at least 4% for four consecutive months.

Here are some go-to sources that are showing non-recession and warnings alike based on the most recent inversion of the yield curve.

According to a Merrill Lynch capital markets outlook on April 8, 2019, from the Macro Strategy team:

Yield-curve inversions share both common and distinct features. They always reflect tightening financial conditions and slowing nominal growth. Their recession message, however, depends a lot on the underlying long-term inflation trend. The brief inversion in late March prolonged the expansion, in our view, because it reflected falling inflation pressures.

In late March, Forbes cited expert opinion that the current inversion put the implied recession risk at 25% to 30% on a 12-month view.

The Cleveland Federal Reserve Bank’s March 28 update did show a higher percentage chance of recession out a year, but that was still just at 32.7%.

Goldman Sachs opined in late March that the most recent yield curve inversion is unusual and that it is not sending the same powerful recession signal it has in the past. Strategists pointed out that it’s more usual to see the two-year yield break above the 10-year yield first, and strategists expect stocks to continue to move higher even as the spread between short-term and longer-term yields narrows.

BlackRock, the manager for the massive iShares exchange traded fund family, opined in March that investors have historically viewed the shape of the yield curve as a signal of future economic growth, but the firm voiced: “We do not believe the current yield curve is signaling a recession, but rather that it reflects the Federal Reserve’s interest rate hikes and decelerating economic growth.”

A Wall Street Journal article in January warned of the yield curve inversion ahead of time and discussed that a true inversion had occurred before the past 5 recessions, but it also warned that the data sees lower odds than the yield curve.

The CME FedWatch Tool is also leaning more toward rate cuts in the future, as opposed to more rate hikes, and that means the inverted yield curve is likely to abate then or ahead of time. That FedWatch Tool most recently showed a 30.6% chance of a 25 basis point rate cut (63.7% at flat rates) for the December 2019 FOMC meeting, and the tool showed a 35.0% chance of a 25 basis point rate cut (55.2% flat chance) for the January 2020 FOMC meeting.

A last source of confidence is that Fed Chair Jerome Powell and the Federal Reserve already have given longer-term views for slower growth but no recession. Most important is that the FOMC already has signaled that it is out of the rate hike business for 2019, and that might mean they figured out they were too aggressive in “buying an insurance policy” with excessive rate hikes in 2018.

One more issue to consider, which should need no sourcing, is the level of the S&P 500 Index and the Nasdaq composite index. The S&P 500 was last seen at roughly 2,905, with an all-time and recent high of 2,940.91. The Nasdaq was recently at 7,990, compared with an all-time high and recent high of 8,133.30. Stock markets can hit highs over and over in the late-cycle moves, but if stock indexes tend to discount news for one or two quarters into the future it seems unlikely that the markets are screaming “recession is imminent.”

Anyhow, there is a montage of calls around the inverted yield curve. We have tried to show both sides, but the reality is that, from the list of go-to sources that don’t just make a living based on headline hype, this most recent inversion is not predicting any massive odds of recession at this time. That can change if the curve gets very inverted and if some yet-unknown outcomes turn south.

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