Recession indicator may be flashing ‘false signal’, yield curve researcher says

Over the months, the bond market has issued numerous warnings that a US recession may be on the way, a view that many in the financial markets have finally accepted.

One is the 10-year minus 3-month Treasury yield spread, which has been below zero since late October but has not been negative long enough to send a definitive statement about an impending economic contraction. Campbell Harvey, now a Duke University finance professor who pioneered the use of the spread as a predictive tool, said the gauge “can send a false signal, which is interesting because I invented the gauge.”

Harvey, who linked the difference between longer-term and short-term interest rates to future US economic growth in his 1986 University of Chicago dissertation, comes at a time when the broader financial market is worried about a possible economic downturn. 2023.

On Tuesday, US DJIA stocks,

It managed to recover from four straight sessions of decline as investors weighed recession fears and the Bank of Japan’s surprise policy shift. According to Dow Jones Market Data, 41 different bond market yield spreads turned negative on Tuesday — a sign of pessimism about the economic outlook.

The difference between the rates on the 3-month TMUBMUSD03M bill,
and the 10-year note has been negative for almost two months — reflecting the 10-year rate trading much lower than its 3-month counterpart — and ended Tuesday’s New York session at minus 66.3 basis points. Such inversions have preceded eight of the last eight recessions. 2- The spread between BX:TMUBMUSD02Y and 10-year yields BX:TMUBMUSD10Y has been consistently below zero for almost six months, although it has emitted at least one false signal in the past, according to Harvey.

Canadian-born economist Harvey said in an interview with MarketWatch that one of the reasons for his current view is that the 3-month/10-year spread as a model “is now so well known that it affects behavior.” both companies and consumers should be more cautious – a form of “risk management” that “increases the likelihood of a soft landing”.

“We’re in a period of slow growth, which fits the pattern, but when it comes to recession, I’m skeptical. A hard landing is unlikely,” he said by phone, though he did not rule out the possibility of a moderate landing. “What I said is true. This is a valuable indicator, and I believe it is accurate in predicting a slowdown in economic growth. In terms of a hard landing, you need to look at other data.”

Source: Tradeweb

Typically, Treasury spreads should widen and trend upward, not downward, as investors consider brighter growth prospects and seek additional compensation for holding the bond or note longer. As the Federal Reserve continues to raise interest rates and investors consider the possible impact of those moves, they shrink below zero or reverse.

On October 26, the 3-month/10-year spread closed the US trading session below zero for the first time since March 2, 2020. At the time, Harvey said he should see the spread stay below zero by December. make sure the recession is on its way. With less than two weeks left to the end of the year, this indicator has not yet been reached.

Here are the reasons the professor now explains why the spread may not be reliable as an indicator of an impending recession this time around, even though it clearly points in the direction of “lethargic” economic growth:

  • Unusual employment situation. While unemployment is low before every recession, it is unusual for labor demand to be as high as it is now in the United States. “This means that laid-off workers can quickly find work.”

  • Technology-driven layoffs. Meta Platforms Inc. Employees laid off from companies such as META,
    The parent of Facebook and Twitter is “highly skilled and has very short unemployment,” unlike the 2007-2008 global financial crisis and the brief 2020 COVID recession, which affected a broader workforce than other industries.

  • Powerful consumers and financial institutions. Consumers and the financial sector are stronger than ever. Harvey said that makes it less likely that a drop in housing prices could cause contagion, or that any problems in the financial sector could quickly spread to the economy.

  • Income adjusted for inflation. Harvey focuses on inflation-adjusted returns because they better reflect the real economic picture. “Once inflation adjusts incomes, the yield curve is not inverted – but flat (related to lower growth, but not necessarily recession),” he said.

  • Behavioral adjustments. According to Harvey, because of the inverted yield curve, companies are less likely to “bet the firm” on a large investment project, plus consumers are cautious and have a lot of savings. “All of this leads to a self-fulfilling prophecy – that is, low growth. However, you can also look at it as risk management. Even if growth slows down, companies can do it without massive layoffs.”

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