Why have so many ‘airtight’ recession predictions been downright wrong?
In investment management, past performance is no guarantee of future returns. In economics, we’ve seen many predictions of a U.S. recession that so far, at least, have not materialized. Investors should take note that the past performance of a key economic tenet — that a recession follows an inverted yield curve — may no longer be as reliable today as it once was.
Let’s first look back at the pace of inflation. When it started to ramp higher in 2021, many economists, as well as the Federal Reserve, dismissed the pattern as “transitory.” But by March 2022, the Fed understood that the new inflation pattern was serious and commenced raising short-term rates. That November, the Fed’s guidance hardened, with Fed Chair Jerome Powell stating that “reducing inflation is likely to require a sustained period of below-trend growth and some softening of labor market conditions.”
At this point, the U.S. Treasury two-year yield was higher than the 10-year yield, creating an inverted yield curve, and rates were rising at the most rapid pace since the early 1980s. For the vast majority of economists, these facts were strong signals to forecast rising unemployment and a U.S. recession in 2023.
Yet as the fourth quarter of 2023 approaches, signs of a U.S. recession are not so clear. The consensus of many economists has shifted away from the recession forecast, although some have merely pushed the timing into 2024, citing lags in monetary policy, or shifted to words like “mild” or “soft landing” to describe any possible future downturn.
Yield-curve indicator breaks down
Why the shift? Regardless of whether we eventually end up in a recession, the key here is how an inverted yield curve may not mean the same as it did 20 years ago. Has our economy become far more resilient in the face of restrictive interest rate policies?
Let’s look at what history shows us. Back in the 1950s, ’60s and ’70s, manufacturing was the engine of the U.S. economy, with the purchase of durable goods often facilitated by credit. If one wanted to buy a house, a 30-year fixed-rate mortgage was the only choice. Moreover, that choice was typically provided by a savings and loan institution that borrowed short-term from savers and lent long-term for houses or medium-term for cars.
Taking interest-rate risk and surviving short periods of inverted yield curves was the savings and loan business model, since efficient rate hedging vehicles were not available. When the Fed hiked interest rates, lending slowed for houses and cars, the economy slumped, and unemployment eventually started to rise.
Fast forward to today. The U.S. is a service-sector economy, and most service purchases do not involve a loan or credit. Mortgages come in all shapes, sizes, terms and maturities, and are originated by specialized brokers that package and sell the mortgages to investors who want to hold this risk. For financial institutions, the ability to hedge and manage interest-rate risk is further supported by deep markets in swaps, futures and options.
Higher rates, which alter the time value of money, still have a profound impact on asset markets, from equities to fixed income. But the impact of those rates on the real economy is much less clear as the U.S. economy evolves. Yet, most econometric models still rely on historic relationships, which don’t take into account recent structural changes impacting interest-rate sensitivity.
Moreover, the last three serious recessions all required something big and systematic to break. In 1991, it was the savings and loan industry and the housing market, brought on by tighter credit conditions. In 2008, it was the financial crisis brought on by risk taking in subprime housing. In 2020, it was the Covid-19 pandemic, which had nothing to do with rates.
This year, the failure of a few niche regional banks could have been the trigger for contagion and a serious banking system collapse. That was not the case because regulators quickly backstopped the system. Additionally, most banks had hedged their positions.
Could it be that a less interest-rate sensitive economy and a regulatory network committed to preventing systemic financial-system breakdowns has reduced the power of an inverted yield curve to forecast a recession? Time will tell. Until then, investors should be cautious about relying on historical parallels as they prepare their portfolios for the risks ahead.
OpenMarkets is an online magazine and blog focused on global markets and economic trends. It combines feature articles, news briefs and videos with contributions from leaders in business, finance and economics in an interactive forum designed to foster conversation around the issues and ideas shaping our industry.
All examples are hypothetical interpretations of situations and are used for explanation purposes only. The views expressed in OpenMarkets articles reflect solely those of their respective authors and not necessarily those of CME Group or its affiliated institutions. OpenMarkets and the information herein should not be considered investment advice or the results of actual market experience. Neither futures trading nor swaps trading are suitable for all investors, and each involves the risk of loss. Swaps trading should only be undertaken by investors who are Eligible Contract Participants (ECPs) within the meaning of Section 1a(18) of the Commodity Exchange Act. Futures and swaps each are leveraged investments and, because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for either a futures or swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles and only a portion of those funds should be devoted to any one trade because traders cannot expect to profit on every trade. BrokerTec Americas LLC (“BAL”) is a registered broker-dealer with the U.S. Securities and Exchange Commission, is a member of the Financial Industry Regulatory Authority, Inc. (www.FINRA.org), and is a member of the Securities Investor Protection Corporation (www.SIPC.org). BAL does not provide services to private or retail customers.. In the United Kingdom, BrokerTec Europe Limited is authorised and regulated by the Financial Conduct Authority. CME Amsterdam B.V. is regulated in the Netherlands by the Dutch Authority for the Financial Markets (AFM) (www.AFM.nl). CME Investment Firm B.V. is also incorporated in the Netherlands and regulated by the Dutch Authority for the Financial Markets (AFM), as well as the Central Bank of the Netherlands (DNB).