Friday, December 13

Why a Historically Reliable Recession Indicator May No Longer Be Accurate

Wall Street’s most reliable recession indicator started signaling trouble in 2022 and hasn’t stopped since, but so far it has proven wrong every time.

The yield on 10-year Treasuries has been lower than that of many shorter-term bonds, a scenario known as an inverted yield curve, which has historically preceded nearly every recession since the 1950s.

Traditionally, an inverted yield curve suggests a recession within a year or two. However, not only has a recession not occurred, but U.S. economic growth remains stable.

This has led many on Wall Street to wonder why this once-reliable indicator has proven wrong this time and whether it still signals economic danger.

“So far, he hasn’t predicted a recession,” said Mark Zandi, chief economist at Moody’s Analytics. “It’s the first time he’s failed to deliver a recession. That doesn’t mean he won’t be right in the end.”

Depending on the yield durations examined, the curve inverts from July 2022 versus the 2-year yield, or from October 2022 versus the 3-month note. Some analysts also consider the federal funds rate, which would place the inversion in November 2022.

Regardless of the method used, a recession should have already occurred. The only previous false alarm was in the mid-1960s, and the inverted curve has predicted every recession since.

The New York Federal Reserve, using the 10-year/3-month curve, still estimates a 56% probability of recession by June 2025.

“It’s been so long you have to wonder if it’s really useful,” said Joseph LaVorgna, chief economist at SMBC Nikko Securities. “How can a curve be wrong for so long? I’m not ready to completely dismiss it yet.”

Other indicators

To further complicate matters, the yield curve isn’t the only early warning sign of the post-Covid economic recovery.

Gross domestic product (GDP) growth has averaged 2.7% annually since the third quarter of 2022, a robust pace above the trend increase of about 2%.

Previously, GDP had been negative for two consecutive quarters, meeting the technical definition of a recession, although few expected an official statement from the National Bureau of Economic Research.

Despite this, several negative trends have been observed. For example, the Sahm rule, which suggests a recession when the three-month average unemployment rate is half a percentage point above a 12-month low, is approaching its trigger point. Additionally, the money supply has been declining since April 2022, and the Conference Board’s leading economic indicators have been negative, indicating potential headwinds to growth.

“A lot of these measures are now under scrutiny,” said Quincy Krosby, chief global strategist at LPL Financial. “A recession seems inevitable at some point.”

What’s different this time?

“We’ve had a number of indicators that haven’t worked,” said Jim Paulsen, a veteran economist and strategist. “We’ve seen recession-like conditions.”

Paulsen, who now writes for his own blog Paulsen Perspectives, highlights several recent anomalies that might explain the situation.

On the one hand, the economy experienced a technical recession before the reversal. On the other hand, the unique behavior of the Federal Reserve in this cycle influenced the results.

In response to the highest inflation in 40 years, the Fed began gradually raising rates in March 2022 and then more aggressively in the middle of the year, a departure from past behavior of raising rates early in the inflation cycle and then cutting them.

“They waited until inflation peaked and then tightened significantly. The Fed was out of sync,” Paulsen said.

This rate dynamic has allowed companies to lock in low long-term rates ahead of Fed hikes, providing a cushion against higher short-term rates.

However, this trend could pose risks for the Fed, as much of this funding is coming to an end. Companies that need to refinance could face challenges if high rates persist, potentially validating the yield curve’s recession signal.

“The curve may have been misleading so far, but it could start to be accurate soon,” Zandi said. “The Fed should consider lowering rates to mitigate risks.”