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Professor behind the recession indicator with a perfect track record says it’s ‘way too early’ to avert a US economic downturn

Stronger-than-expected economic data has forced some on Wall Street to push back or even scrap calls for a recession, once widely seen as a certainty.

But one recession indicator is still sending a code red signal for the US economy: the government bond yield curve.

The inverted yield curve indicator, which occurs when three-month Treasury yields exceed ten-year Treasury yields, is a perfect 8-out-8 that precedes every recession since World War II.

Its inventor, Duke professor and Canadian economist Campbell Harvey, still sees a recession ahead, even though the economic narrative has become more optimistic in recent weeks. “It’s way too early to say this is a false signal,” Harvey told Yahoo Finance. “Way too early.”

Thanks to Harvey’s work, investors have long focused on an inverted yield curve as a sign of an impending economic downturn.

Some monitor the spread between two- and 10-year government bonds for signs of an inverted yield curve. But Harvey’s definition takes advantage of the difference between three-month notes and ten-year notes, a spread that turned negative nine months ago, in November 2022.

Prior to the last eight U.S. recessions, the average time between a yield curve inversion and the onset of a recession was 11 months, according to Harvey research. During the past four recessions, the average lead time was longer, namely thirteen months. This time, Harvey expects a recession to likely begin in early 2024.

‘The longer we go [without a recession] after the inversion, people start doubting the indicator, and that’s fine,” said Harvey. “I characterize it as the calm before the storm.”

Table of Contents

‘The Narrative Twists’

At the beginning of this year, a recession in 2023 was widely predicted. But it failed to do so, with Federal Reserve officials recently joining the growing list of market participants who no longer see a recession hitting the US economy.

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This conversation has in part raised the question of whether interest rate inversion is still a good indicator.

In a July research paper titled “The Narrative Turns,” Goldman Sachs chief economist Jan Hatzius lowered the likelihood of a recession in the next 12 months from 25% to 20%.

Hatzius cited resilient economic data and cooling inflation, noting, “We do not share widespread concerns about yield curve inversion.”

“The argument that the inverted curve confirms the consensus forecast of a recession is circular, to say the least,” Hatzius wrote.

Not the ‘end of the story’

In January, Harvey posted on LinkedIn that he had “reasons to believe” that the yield curve was “giving a false signal.”

At the time, he noted that key components of the stimulus-fuelled economy were still at play in the pandemic era. Excessive labor demand, a strong consumer position and a healthy financial sector all indicated that the US could avoid a recession.

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“The main wildcard is the Fed,” he wrote in early January. “I believe now is the time to end the tightening.”

Since then, the Fed has raised its benchmark rate by more than 100 basis points to its highest level since 2001.

A regional banking crisis ensued, culminating in the bankruptcy of three major banks. As a result, lending by major banks slowed in the second quarter and credit conditions are expected to remain tight until the end of the year.

This, according to Harvey, is key to the fact that the economic slowdown is yet to come. While a historically low unemployment rate may be an argument for why the economy remains resilient, it is a lagging indicator.

The yield curve indicator should be seen as a warning sign for the future.

“A lot of people think [the yield-curve inversion] as a kind of cause of recessions,” Liz Ann Sonders, chief investment strategist at Charles Schwab, told Yahoo Finance. “That’s not really one of the ways to think about it. It is the conditions that develop that cause the yield curve to invert, and ultimately cause the contraction of the economy.”

Both Sonders and Harvey explained that the yield curve inversion in itself means that banks are in a difficult position.

Financial institutions generally borrow short and borrow long.

For example, for many consumers, the interest they pay on a 30-year mortgage – the long-term money the bank has lent them – could be lower than the rate they pay for parking cash in a savings account with high efficiency. , money that the bank essentially pays the consumer to borrow.

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For example, in the second quarter deposit rates of banking giants such as JPMorgan (JPM) and Wells Fargo (WFC) rose sharply, driving up interest costs at these companies.

Jamie Dimon, CEO of JPMorgan Chase, testifies at the Senate Banking, Housing and Urban Affairs Committee hearing titled Annual Oversight of the Nations Largest Banks, in Hart Building on Thursday, September 22, 2022. (Tom Williams/CQ-Roll Call, Inc via Getty Images)

Higher interest rates also depress the value of assets such as mortgages and other long-term loans held on a bank’s balance sheet, a dynamic investors learned all about after the collapse of Silicon Valley Bank.

“That limits lending and in turn limits investment and the economy,” said Sonders.

In recent weeks, warnings of possible stress in the financial sector have also piled up.

On Monday, S&P Global downgraded the bond ratings of several US regional banks. This followed Moody’s downgrade of ten medium-sized institutions earlier this month, and a warning from a Fitch Ratings analyst that the entire industry could be downgraded from AA- to A+.

The Fed didn’t stop [raising rates] and this created other tensions, such as on the financial system,” said Harvey. “We achieved that in March and I don’t think this is the end of the story.”

Josh Schafer is a reporter for Yahoo Finance.

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