Market Extra: U.S. recession indicator is `not flashing code red’ yet, says pioneering yield-curve researcher


Amid the debate over whether the U.S. is about to head into an economic downturn, the Duke University finance professor who pioneered the use of bond-market yield curves as a predictive tool has a few things to say.

One is that it’s too soon to say whether a contraction is on the way, though the world’s largest economy appears poised for a slowdown, according to Campbell Harvey, whose 1986 dissertation at the University of Chicago determined that the difference between long- and short-term interest rates was linked to future U.S. economic growth. Moreover, he says, the recent brief inversion of the 2-year, 10-year Treasury spread needs to persist for three months to provide a meaningful signal.

“Everything is pointing to slower economic growth,” said Harvey, a 63-year-old, Canadian-born economist. Referring to the narrowing of spreads between long- and short-term rates seen in various parts of the U.S. Treasury market in recent months, he says that “any flattening is likely associated with slower U.S. economic growth. And it’s reasonable to expect flattening across the whole curve, given the Fed is in a tightening cycle.”

“When it comes to the slope of the yield curve, flat is bad and inverted is really bad,” he told MarketWatch in a phone interview on Thursday. “And right now, the yield curve is not flashing code red for a recession.”

Ordinarily in a healthy economy, yields spreads widen as investors price in brighter growth prospects well into the future, causing the Treasury curve to slope upward. Conversely, spreads flatten when the outlook is more pessimistic, and can even fall below zero and invert.

Historically speaking, the yield spreads don’t typically approach zero until interest rate hikes by the Federal Reserve are well under way. This time around, though, a handful of spreads are inverted while others are teetering on the brink at a time when the Fed has delivered only one quarter percentage point increase in its benchmark policy interest rate, though policy makers are poised to deliver more hikes.

In particular, the widely followed spread between 2- TMUBMUSD02Y, 2.523% and 10-year Treasury yields TMUBMUSD10Y, 2.715% has flattened at a faster speed than any other time since the 1980s, even before the Fed’s quarter-point hike on March 16. It fell below zero on March 29 and stayed inverted for just a few days, triggering a debate over its usefulness as a recessionary signal. It was the spread’s first inversion since Aug. 30, 2019 which preceded a two-month downturn in 2020 due to the pandemic.

Gargi Chaudhuri, head of iShares Investment Strategy for the Americas at BlackRock Inc. BLK, -1.71%, said in a note on Friday, “We do not see a recession occurring in the near-term.” Her remarks came a day after policy maker James Bullard of the St. Louis Fed said officials can substantially raise interest rates without hurting the economy. Former U.S. Treasury SecretaryLawrence Summers, on the other hand, told Bloomberg Television he expected economists to come around to a consensus view that a U.S. recession in the next couple of years “is clearly more likely than not.”

Economic downturns tend to follow a 2s/10s yield inversion with a lag of roughly 20 months, and in some cases more than two years. Such an inversion can also impact the psychology of companies, making them more reluctant to spend.

But there’s one extremely important caveat, said Duke’s Harvey: “An inversion needs to last for a quarter — a day or a week just isn’t meaningful — and that’s not happened.” He credited the speed of the 2s/10s flattening since November to “a miscalibration of people’s inflation expectations,” and not necessarily a sign that a deeper inversion is on the way.

Like Fed Chairman Jerome Powell, Harvey pointed to the shortest end of the Treasury market — the bills sector — as the starting point for a more relevant indication of where the economy may be heading. The spread between rates on the three-month bill TMUBMUSD03M, 0.690% and 10-year note is still more than 200 basis points — suggesting to some that economic growth can continue. Like its 2s/10s counterpart, the 3m/10y spread also inverted in 2019, ahead of the February-April 2020 recession.

Even though the 3m/10y spread is positively sloped, “it’s reasonable to suspect there will be substantial flattening over the next year,” Harvey said.

“Economic theory is clear: What you care about is where growth will be, starting from now,” he said. “And for that, you need to anchor it to the short-term yield. Given expectations for Fed rate hikes, it’s reasonable to think that the 3-month rate is going up.”

The 3-month bill, now hovering around 0.68%, only reflects Fed hikes that have actually been delivered — whereas the 2-year rate, at around 2.5%, captures expectations for future rate increases. Many observers say the central bank is now far behind the curve when it comes to tackling inflation.

Read: Opinion: It’s now clear that the Federal Reserve has made a huge monetary-policy error

Complicating the economic outlook is an issue that hasn’t received nearly as much attention as the yield curve, inflation, or the prospect of more Fed rate hikes: The federal-debt-to-GDP ratio, which was more than 100% at the end of last year.

When interest rates rise, so do the U.S.’s debt-service payments which, in turn, will boost the size of the government’s fiscal deficit, according to Harvey. “The Fed will need to take that into account. What is the implication if we push rates up? Ultimately, the Fed’s goal is to get inflation under control in a way that doesn’t damage employment — a soft landing. That task is highly complicated and the fact that debt-to-GDP is so high makes this a much more challenging problem.” 

On Friday, Treasurys sold off across the board, pushing the 10-year yield above 2.7%. The 2s/10s spread toggled between steepening and flattening during the day as investors continued to assess the Fed’s most likely policy path. Meanwhile, major stock indexes were mixed, with Dow Jones Industrial Average DJIA, +0.40% up more than 180 points, or 0.5%, in late afternoon trade and the S&P 500 SPX, -0.27% and Nasdaq Composite COMP, -1.34% both lower.

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