Dreaded recession indicator has never been wrong before - but do we have anything to worry about now?

Recession indicator moves

Traditionally, when a country's bond market yield curve becomes inverted, it is taken as a warning sign. The 'magic term' simply means that yield levels are higher for short maturities than for long maturities. Understandably, this phenomenon cannot be considered healthy, since under normal circumstances, bond market investors perceive higher risks over the longer term, which are harder to predict, i.e. they expect higher returns on their longer-term bond investments.

This is a particularly hot topic today,

BECAUSE THE US YIELD CURVE IS INVERTED IN A WAY NOT SEEN SINCE THE 1980S.

An abnormal shape of the yield curve means that investors are somehow less willing to invest in the short term, or only invest in the short term with higher returns than longer-term investments. As regards the causes of bond market movements, there are basically two possible interpretations:

• On the one hand, the market may be pricing in that the Fed will quickly beat inflation, so in the longer term it will no longer be necessary to maintain the current high interest rate environment (Fed rate hikes automatically trigger a rise on the short end of the yield curve, since why would anyone invest in bonds if they can realise high interest rates in the short term on the interbank market with much less risk).
• On the other hand, there is always a less optimistic interpretation of the inverted yield curve: investors may also be pricing in that central bank rate hikes will dampen economic growth, and a significant fall in activity means that the central bank will have to cut in the longer term to stimulate the economy.

Of course, the above two things are partly related, since a slowdown in the economy brings a fall in inflation, which means that the central bank is trying to bring down inflation by holding back growth. While the Fed maintains that soft landing remains possible, i.e. inflation can be reduced even without a recession, this has rarely been achieved in reality, and it is clear as day that today's Fed will not be deterred even by the possibility of a recession from combating inflation. What gives the inverted yield curve its 'magical power', however, is that in modern US economic history this abnormality has always been followed by a recession.

But today's situation is anything but ordinary. Inflation has not been driven primarily by an overheating economy, but by the imbalance in supply constraints caused by excess demand fuelled by government subsidies and disruption from the coronavirus (especially in the US), and by the energy shock from the Russia-Ukraine war (felt more in Europe, in addition to the first factor). And the central bank reaction to supply-side inflation may be different from that to pure demand-side inflation, and hence the interpretation of market reactions may be different.

Expectations about US monetary policy have an impact on everything, including Hungary's forint, so it is important to know exactly how to decipher today's market-economic developments from a domestic perspective. We asked economist Andreas Jobst, Head of Macroeconomic and Capital Markets Research at Allianz in Munich, about this.

Is recession around the corner or will the infamous indicator trick us?

Considering that inflation remains driven mainly by supply issues, is the economic slowdown necessarily needed to lower the price dynamics (as is the case when inflation is demand-driven)?

Andreas Jobst: Arguably, we are operating in a different regime for central banks and the way they formulate their monetary stance. Traditionally, raising policy rates, and, thus, tightening financing condition, is an effective way of mitigating demand-driven inflation. This is generally referred to “divine coincidence” – central banks aim to cool the economy to restore price stability.

However, if inflation is driven by supply side factors, i.e., cost-push, such as higher energy prices, especially if caused by an external shock, it is much harder for central banks to achieve their mandate without causing a recession – changing the financing conditions does not raise the supply of gas, to take the current European dilemma. So there is indeed a real risk that central banks would need to be excessively restrictive in raising rates to lower aggregate demand below what would otherwise be necessary if inflation were driven by higher consumption and/or investment.

The risk of “hiking” the economy into a recession is real – and it is greater in Europe, where inflation is still more driven by energy prices (which contribute slightly less than 50% to overall inflation).

However, this does not necessarily mean that we will need to have a recession for inflation decline to the 2%-inflation target. Energy and food prices seem to be coming down now, and wage pressures from the labour market remain contained – I expect stagnation this year with a shallow (L-shaped) recovery of growth next year.

Is the steeply inverted yield curve a sign of expectations of a recession, or quite the opposite: the bond market’s bet shows that they expect the Fed’s easy victory over inflation?

The inverted yield curve has been a tried-and-trusted leading indicator for recessions. Admittedly, circumstances are different this time – QE has already compressed the term premium resulting in a relatively low steepness of the curve even before the economic slowdown, and the Fed has been much more aggressive in raising rates compared to past hiking cycles. Most importantly, the inversion is much more driven by policy rate expectations (so the short end) rather than growth prospects (and the future need to hike rates, affecting the long end).

With this in mind, I expect a somewhat lower early warning capacity of the inverted yield curve.

The still strong labour market data in the US suggest that the Fed can afford to be hawkish, which will perpetuate the yield curve inversion – but also builds up the risk of causing a recession (since monetary policy operates with a lag of between 6-9 months regarding its impact on real activity).

In your view, is there a possibility of a ’soft landing’?

Despite rapid monetary tightening and elevated inflation, the economy has proven resilient so far thanks to strong exports and consumption. A soft landing in the US is still possible – so far, the strong labor market and excess savings have kept the US economy afloat. I am worried if US households (whose decline in real disposable income has been higher than in Europe but decided to rack up credit card debt to compensate) cut back on consumption, which is likely to derail growth. In addition, the housing market remains under pressure and some further price correction to the tune of 10% is very realistic.

How do you see the near future of the US economy? What is your institution’s growth forecast for next two years?

We expect GDP growth to fall -0.3% in 2023, with the recession during H1 2023, before picking up by a modest +1.6% in 2024, held back by fiscal consolidation and still elevated real interest rates.

Lower household savings and a strong labour market bolster consumer spending; however, the housing market has continued to weaken rapidly since the summer: home sales and mortgage loan demand have dipped amid tighter financing conditions and falling residential investment.

Cover photo: Getty Images