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Wall Street’s most trusted recession indicator began signaling trouble in 2022 and hasn’t stopped since, yet it has been incorrect at every turn so far.
The yield on the 10-year Treasury note has been lower than many shorter-term bonds, a scenario known as an inverted yield curve, which has historically preceded nearly every recession since the 1950s.
Traditionally, an inverted yield curve suggests a recession within one to two years. However, not only has a recession not occurred, but U.S. economic growth remains steady.
This has left many on Wall Street questioning why this once-reliable indicator has been wrong this time and whether it still signals economic danger.
“So far, it hasn’t predicted a recession,” said Mark Zandi, chief economist at Moody’s Analytics. “It’s the first time it has failed to lead to a downturn. That doesn’t mean it won’t eventually be correct.”
Depending on the yield durations examined, the curve has been inverted since July 2022 against the 2-year yield, or since October 2022 against the 3-month note. Some analysts also consider the federal funds rate, which would place the inversion at November 2022.
Regardless of the method used, a recession should have already occurred. The only previous false alarm was in the mid-1960s, and the inverted curve has predicted every downturn since.
The New York Federal Reserve, using the 10-year/3-month curve, still estimates a 56% probability of recession by June 2025.
“It’s been so long that you have to wonder about its usefulness,” said Joseph LaVorgna, chief economist at SMBC Nikko Securities. “How can a curve be wrong for so long? I’m not ready to dismiss it entirely yet.”
Other Indicators
Further complicating matters, the yield curve is not the only cautionary signal regarding the post-Covid economic recovery.
Gross domestic product (GDP) growth has averaged 2.7% annually since the third quarter of 2022, a robust pace above the trend increase of about 2%.
Previously, GDP was negative for two consecutive quarters, meeting the technical definition of a recession, although few expected an official declaration from the National Bureau of Economic Research.
Despite this, several negative trends have been observed. For instance, the Sahm rule, which suggests a recession when the three-month average unemployment rate is half a percentage point above a 12-month low, is nearing its trigger point. Additionally, the money supply has been decreasing since April 2022, and the Conference Board’s leading economic indicators have been negative, pointing to potential growth headwinds.
“Many of these measures are now under scrutiny,” said Quincy Krosby, chief global strategist at LPL Financial. “A recession seems inevitable at some point.”
What’s Different This Time?
“We’ve had several indicators that didn’t work,” said Jim Paulsen, an experienced economist and strategist. “We’ve seen recession-like conditions.”
Paulsen, now writing for his blog Paulsen Perspectives, highlights several recent anomalies that might explain the situation.
On one hand, the economy experienced a technical recession before the inversion. On the other hand, the Federal Reserve’s unique behavior in this cycle has influenced outcomes.
In response to the highest inflation in over 40 years, the Fed began raising rates gradually in March 2022 and then more aggressively mid-year, diverging from past behavior where rates were increased early in the inflation cycle and then cut.
“They waited until inflation peaked and then tightened significantly. The Fed was out of sync,” Paulsen explained.
This rate dynamic allowed companies to secure low long-term rates before the Fed’s hikes, providing a cushion against higher short-term rates.
However, this trend could pose risks for the Fed, as much of this funding is nearing expiration. Companies needing to refinance could face challenges if high rates persist, potentially validating the yield curve’s recession signal.
“The curve might have been misleading so far, but it could start being accurate soon,” Zandi said. “The Fed should consider lowering rates to mitigate risks.”
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