Recession fears soared last week because of something called an inverted yield curve which exists when investors shift their cash from shares into the relative safety of government bonds. That drives the price of bonds up, and, the flip side, interest rates down. Since recessions last a while, investors, when fearing a recession, prefer longer-term to shorter-term bonds. With more cash flowing into, say ten-year Treasury bonds than its IOUs with only a three-month duration, the price of the longer-term bonds rise relative to its shorter-term cousin. That drives the interest rate on the long bond down relative to the three-month IOU.
If rates on these long-term bonds fall below those on short-term notes, we have an inversion. Investors are telling the U.S. (and other) governments that if it wants to borrow, say, $10,000 for three months they want an interest rate of 2%, but if the government will (please) take their money for ten years they will charge only, say, 1.5% or, in some countries, pay them to take it. Just the opposite of what faces savers, who can get an interest rate of only 0.60% for lending the bank money for six months, but 2.65% for lending for six years.
Central banks can add to the upward price pressure on long-term bonds by buying them, in the hope that the resultant fall in interest rates will make it cheaper for private-sector players to borrow and invest in houses, factories and other assets, thereby shortening the recession.
Bloomberg estimates that a protracted inverted yield curve has preceded seven of the last nine recessions. Other tabulations differ in detail, but all agree that the majority of recessions are preceded by an inversion, although not one that lasted only a few hours, as happened last week. Credit Suisse reckons that inverted yield curves are canaries that chirp early warnings. Share prices plunge about 18 months after an inversion, and economies falter about 22 months after short-term interest rates top longer-term rates. But that average conceals quicker responses, making an inversion relevant to the presidential and congressional elections only 14 months hence. Ray Dalio, founder of Bridgewater Associates, the world’s largest hedge fund, puts the chance of a recession before the 2020 elections at 40%. And adds that reducing interest rates this late in the business cycle may not be effective in stimulating the economy.
Recoveries are sharp. Returns on the S&P 500 averaged 15%, 40%, and 79% one, five and ten years respectively, after the end of recessions, according to Ben Carlson, investment advisor at Ritholtz Wealth Management LLC.
Last week’s inversion is not the only development causing economic forecasters to take a new and gloomier view of the outlook. One is that no nation in this globalized world is an economic island, entire of itself. Not even the United States, with an economy that is the envy of most of the world.
- The U.S. economy continues to grow at a satisfactory annual rate of about 2%, perhaps a bit higher;
- Consumers continue to spend. Retail sales rose in July, and leading retailer Walmart last week raised its full-year profit forecast, and predicted that sales in 2020 would increase by 2.5%-3.0%.
- Unemployment is at or near record low levels. There are one million more job openings than job seekers, and employers complain that labor shortages are limiting their growth.
- Productivity grew at a healthy 2.3% rate in the second quarter.
This, despite the drag from weaknesses in other major economies. Once-mighty but export-dependent Germany finds itself with a shrinking economy. Debt-ridden China is having difficulty overcoming the loss of US markets resulting from Trump’s tariffs. Britain is in the throes of Brexiting, one way or another. Italy’s economy is stagnant at best. Maduro’s Venezuela is an international basket case. Argentina seems ready to shed austerity in favour of a return to profligate Peronism.
Then there is a general feeling that things are falling apart, that the center cannot hold. So-called populist parties, generally but not always of the Right and at times violent, are dominating the politics of many European countries. India has taken over Kashmir, putting it and Afghanistan — both nuclear powers — at swords drawn. Protesters in Hong Kong have moved from peaceful to violent protest, testing the patience of Xi Jinping, a man not famous for an over-supply of that virtue. Iran is threatening free passage of the Strait of Hormuz. Putin is seeing how far he can push his program of recreating the Soviet Union without triggering a meaningful response from NATO. America’s politicians are seeking office on platforms that promise major changes in the nation’s constitutional structure and its capitalist system. Investors and executives, having ingested this sort of news with their morning coffee, have reason to reach their offices with a less-than-optimistic view of the future prospects of the global economy. Bad news, since most forecasters say that if a recession comes, it will not be because consumers zip their purses and wallets, but because businesses cut back on their investment plans.
In addition to those problems, we have the U.S.-China trade war. Whatever the reasonableness of its long-term objectives, and even The New York Times’ liberal columnist Tom Friedman writes, “The president was right … The game had to be called … I was a fan of getting tough,” — Trump’s tariffs are a drag on global growth. They slow trade – fewer goods and services exchange hands, hitting especially the manufacturing sectors, and reducing the efficiency with which economies operate. And business decision-makers, trying to understand the administration’s policy, if it indeed it has one, struggle to divine the life-span of the tweet imbibed with their morning coffee. Or which competing adviser has won the day’s war for Trump’s ear.
Which is a pity, since it is policy that will make the difference between an inversion that will be followed by a recession, and one that is sounding an alert that a slow-down is imminent, but can be avoided. As Invesco’s Kristina Hooper reminds those of us who might need reminding, “Business cycles typically end with policy mistakes … in most instances by the … US Federal Reserve … over-aggressively raising short-term rates…”. No such error is likely by Fed chairman Jay Powell, who has lowered rates and will lower them further next month, perhaps by half-point rather than a mere quarter, and according to several forecasters, will be followed by still another cut closer to year-end.
There is also an emerging consensus that the time has arrived to fill America’s pot-holes, smarten its airports, rebuild its bridges, replace lead water pipes. Trump wants faster growth – he prefers a rate of 4%-6%, will grumpily settle for 3% — and the Democrats’ trade union supporters always favour more jobs, so a compromise on funding and other details is possible. After all, if the government can borrow long-term at under 2%, it shouldn’t be difficult, as Harvard’s Larry Summers continually points out, to find infrastructure projects that yield social returns in excess of that figure, and that can be executed efficiently.
And it is possible that the private sector might support any such policy. Some 25% of the U.S. population is between the age of 18 and 34, a group broadly called the millennials. They are finding jobs, seeing their earnings headed up, increasingly able to move off their parents’ couches and buy their own, for delivery to their own homes. Aided by low mortgage rates, mortgage applications for new home purchases rose 11% in July from June and were up 31% from year-earlier levels, according to the Mortgage Bankers Association. First-time home buyers, probably including many millennials, accounted for an important part of this increase. If demography is destiny, the importance of millennials in the U.S., along with sensible fiscal and monetary policies, might prove enough to counteract any dampening effect of an inverted yield curve.
Inversions have the good grace to provide ample time to react to their warning. Time enough to adjust policy to avoid the problems of which the inversion, should it be prolonged, is warning. That would be good news were it not that it takes longer to formulate and implement a sensible policy than to unleash a tweet repudiating it.