Why Recent Market Inversions Don’t Guarantee a Recession
After what seemed like almost an inevitability, the 2-year/10-year part of the Treasury yield curve inverted briefly on Tuesday (for 23 seconds, to be exact). The 10-year yield ultimately finished higher on the day, but perhaps only for the time being. Other parts of the curve (e.g., 3-month/10-year, 5-year/30-year, etc.) remain flat, but not inverted.
Tuesday’s inversion will undoubtedly garner a lot of press, since inversions have been a somewhat reliable signal of a coming recession. Every recession over the last four decades was preceded by an inversion, but like most signals it has its shortcomings. Here’s our take on what it means.
How We Got Here
Over the last six months, the yield on the 2-year Treasury moved from 0.2% in late September to its current level of 2.4% reflecting expectations for tighter monetary policy in order to fight abnormally high inflation. Longer-dated yields moved higher as well, but not to the same degree since the 2-year Treasury is heavily influenced by expectations for future Fed policy (the 10-year moved from 1.3% to 2.4% over the same period). Some investors believe the Fed is late in fighting inflation and will need to tighten aggressively in order to get inflation under control. That expectation for an aggressive Fed would, in the market’s mind, force the US economy to tip over into recession, much like the driver of a car that needs to hit the brakes to avoid a crash. While the crash may be avoided (i.e., substantially higher inflation), you're likely to spill the coffee in your cup holder, among other disruptions inside the vehicle.
The Signal’s Shortcoming as a Timing Tool
And yet, despite the attention it garners, curve inversions are a poor predictor of near-term returns. In fact, stocks have historically done well for some time after the initial inversion. Similarly, curve inversions don’t tell you when, or with 100% confidence if, a recession will occur. Over the last four decades, a follow-on recession has occurred anywhere from a few months to a couple years after an inversion.
Why This Time May Be Different
As briefly mentioned above, there is no guarantee that a recession will follow a curve inversion. While market forecasters often anchor to historical precedent, each episode is unique. One could argue that the inversion signal “got lucky” in 2020 when the pandemic and lockdowns forced a deep but short-lived recession. That recession followed an inversion in mid-2019, but what if that exogenous shock never occurred? Would the signal have provided a false positive? We’ll never know.
As we consider the economic conditions today, there are a few reasons to believe this time may be different:
- The global economy has meaningful momentum behind it with nearly all major economies growing above-trend. We expect the US, in particular, to grow at a ~3% pace this year, after having grown ~6% last year. This momentum makes a slowdown more likely than a recession, in our opinion.
- Relatedly, it should also be noted that there are no obvious imbalances in the economy, especially vis-à-vis leverage in consumer and corporate balance sheets. An economy without such imbalances should therefore be better able to handle a Fed hiking cycle and any resultant slowdown.
- Further, corporations have navigated the recent inflationary period well using pricing power and cost structure flexibility to expand margins. Their profit growth has underscored this point. Earnings grew roughly 50% last year (off of a low base year in 2020) and are still expected to grow ~9% in 2022.
- Corporate strength is further exemplified in job openings. Data released this week showed 11 million job openings in the US, equal to levels over the last few months and the highest since the Bureau of Labor Statistics began tracking the data in 2000. Hiring to fill those positions should add additional support to the economy this year.
An inverted yield curve is a sign worth watching as it has historically signaled a shift in the economic cycle for the worse. However, given the state of the US economy, we believe a recession over the near term is unlikely. As always, we reserve the right to change our minds, and when we do, we’ll let you know.
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