A recent yield-curve inversion on the bond market, widely considered a negative economic sign, may not mean an imminent recession this year but one is still a possibility through next year, say some Indiana economists.
Financial headlines of late have focused on the inversion curve, which happens when shorter-term treasury bonds pay higher interest rates than longer-term bonds.
Economists say that inversion is an indication that investor confidence in the economy is down, as small gains in bonds might be better than potential losses by holding stocks into a recession.
Also, stocks last week declined for the third straight week on persisting signs of a global economic slowdown and renewed yield-curve worries.
“It is a relatively solid signal of an economic downturn as signals go. It hasn’t been wrong, but that doesn’t mean it can’t be wrong now,” Robert Guell, professor of economics at Indiana State University. “That has only happened in the past in advance of what has ultimately become a recession.”
Guell said he does “not think a recession is coming yet, but it is not out of the realm of possibility. President [Donald] Trump’s trade policy is making things much more likely for a recession.”
During the last 50 years, yield curve inversions have occurred before each of the last seven recessions, said Larry Deboer, professor of agricultural economics at Purdue University. And each time a recession started within five to 16 months, he said.
This year, the first inversion happened in May, making it possible for recession between October this year and September next year, Deboer said.
Yet there is an exception to the indicator being right every time, Deboer said, pointing back 53 years to 1966.
“The Federal Reserve was raising interest rates trying to combat inflation and the financial markets got pessimistic and the yield curve inverted. The president of the United States, Lyndon Johnson back then, put enormous pressure on the Fed to reduce [interest] rates, which they did and the recession did not follow,” Deboer said.
It would be several years before another recession, he said.
“This is all a measure of confidence,” Deboer said. “It is weird, in a way, because sometimes the markets act as a yield curve inversion causes a recession, but all it is really is a read on what they [investors] are really thinking.
“If they are shifting money to long-term bonds from short-term bonds and depressing long-term rates and raising short-term rates, it is because they think something is going to go wrong in the near term,” he said.
A tough time to read signals
Kevin Christ, associate professor of economics at Rose-Hulman Institute of Technology, said that while historically, a yield curve inversion signals an increased probability of recession, “no one really knows because we are in a much different interest rate environment than at any time since the 1950s.
“Long-term interest rates have not been this low since the 1950s, and the fact of the matter is we simply don’t know if we can interpret yield curve movements the way we have in the past.”
A probability model based on the yield curve, Christ said, currently indicates there is a 35 percent probability that the U.S. economy will be in a recession 12 months from now.
While the economy seems to be strong, as retail sales for the month of July were up the most in the past four months, in general, “retail sales are a poor advance indicator. In early 2007, retail sales were growing at a 6 percent annual rate. In December 2007, the country entered the worst recession since 1982,” Christ said.
One reason for investor skepticism is the on-going trade war with China and tariffs, especially on agriculture, but potentially on other goods, Deboer said. The Trump administration last week stated it would wait until Dec. 15 to impose increased tariffs on Chinese goods that were supposed to go into effect in September.
“It is one thing that is creating uncertainty and disrupting supply chains and reducing demand and raising input prices. That is one of the sources of pessimism, and it is pessimism about the near future that cause the yield curve inversion,” Deboer said.
Another factor, Guell said, is the Federal Reserve System has been holding down short-term interest rates since the Great Recession of 2007-2009.
Interest rates, Guell said, “have never been as manipulated by the Fed, in my view, over such a long period of time. Literally the short term interest rates in the United States have been ... near zero for a very long time, and short term interest rates were pushed way down” after the Great Recession, Guell said.
Because of that, Guell said he is “not comfortable using a normal signal” such as a yield curve inversion “in an abnormal [economic] world.”
In July, the U.S. set a record with 121 months of expansion, DeBoer said, making it the longest economic expansion in U.S. history, beating the record from 1991 to 2001.
“It is strange, as it is both the longest and the slowest expansion in history, but also the steadiest,” DeBoer said. “The American economy has never been as steady as these last 10 years, with growth rates ranging from 1.5 to 3 percent GDP [gross domestic product] and that will never happen again,” Deboer said.
Because of that, Deboer said some investors may say the U.S. economy “can’t go on much longer, so it could be fear of an aging expansion,” he said.
No economic island
Guell also points to European negative interest rates as a result of a weak overall economic activity with the United Kingdom about to leave the European Union and China’s economy is slowing. However, the U.S. economy has been growing, especially in the past two years, he said.
“But, we don’t live on an island economically,” Guell said. “Our continued economic health against the headwinds of the rest of the world slowing down will be really hard to maintain. The fact that Americans are buying cars, furniture and carpet and clothing, that can happen in isolation for a while, but is not going to happen in isolation in perpetuity.”
Christ said he is “concerned about long-term, perhaps even generational, adverse effects on our economy attributable to steps we are taking that represent a backing away from globalization. I am worried that 20 years from now our country will be poorer because of decisions about trade and immigration that are being made today,” he said.
For now, the best way to avoid a large recession, Guell said, is for the U.S. to stop its trade war with China. Then, Guell, who refers to himself as a conservative Republican, said the U.S. government should take advantage of historically low interest rates to build the national economy further through road and bridge repair/construction projects as well as improving ports, all of which can have “decades of economic impact” and stability, Guell said.
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