Does the Inverted Yield Curve Mean We’re Headed for Imminent Recession?

At the top of the list of concerns right now is the inverted yield curve. The behavior of the ten-year bond and the three-month bond has long been considered a sure sign of an impending recession as there has been a period of inversion before every major decline. The inversion is when the yields of the ten-year bond fall below the yields of the three-month bond. The markets are assuming that this will prompt the Fed to start cutting rates as they would be reacting to the possibility of a recession, but the Fed is pushing back on this assumption by pointing out that rates are already very low and further reduction would have little impact. They also point out that inflation threats are far from non-existent.

As a predictor, there are some flaws in the yield curve assumption. The first is that there is often a significant time lag between when the yield curve inverts and the recession starts—sometimes it may take as long as six to nine months. This is not an imminent warning and generally combines with several other indicators of a severe slowdown—some of which are starting to appear while others are not. The second potential flaw this time around is that rates are already very low and the Fed has little room to maneuver. It is hard to see what a tiny rate cut would mean at this stage. That said, there is growing sentiment that the Fed may have to lower rates this year anyway—even if it is mostly a symbolic gesture.

There are other signals of a slowdown to consider. Both the Purchasing Managers’ Index and the Credit Managers’ Index have seen precipitous declines lately, though they remain in the expansion zone. Worse news, the PMI data for Europe is even lower and sinking faster.

What makes anticipating a recession more than a little challenging right now is that for every negative indicator there is one that points in a generally positive direction. The unemployment rate remains very, very low and every month it seems that employers are still adding workers. There have been hikes in terms of durable goods as well as factory goods and there has been steady performance as far as capacity utilization is concerned. There is momentum at work right now—reaction to the tax cuts of last year has faded somewhat but the impact is still being felt. More importantly, the less talked about effort to reduce regulatory pressure has been fueling significant levels of expansion. The reduction of the Bank Reform Act, for example, has freed smaller banks to get engaged and they are generally the lifeblood of both manufacturing and the farm sector.

The bottom line may be that there really isn’t one right now. The economy is capable of more growth, albeit at a slower pace than was the case last year, and it is quite capable of falling off dramatically—perhaps even to the point of recession. There will be lots of attention focused on the continued behavior of the stock market, consumer confidence as well as actual consumer behavior, and there will be a lot of concern directed towards the global economy. A somewhat weaker U.S. economy will not be able to withstand a collapse in the global economy and right now that seems a distinct possibility.