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

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

One of them is the 10-year minus 3-month Treasury yield spread, which has been below zero since the end of October, but it hasn’t been negative long enough to send a definitive statement on a pending economic contraction. Now Campbell Harvey, the Duke University finance professor who pioneered the use of that margin as a forecasting tool, says the indicator may be sending a “false signal, which is interesting because I’m the one who invented the indicator.” “.

Harvey’s startling conclusion, whose 1986 thesis at the University of Chicago linked the difference between long-term and short-term interest rates to future US economic growth, comes at a time when the broader financial market has been concerned about a possible economic downturn in 2023. .

On Tuesday, US stocks DJIA,
+0.60%

SPX,
+0.39%
They were trying to recover from four straight days of declines, as well as back-to-back weekly losses, as investors weighed recession fears and a surprising policy change by the Bank of Japan. Within the bond market, 44 different yield spreads were negative as of Monday, according to Dow Jones Market Data, a sign of pessimism about the economic outlook.

The differential between the rates on the 3-month invoice TMUBMUSD03M,
4,308%
and the 10-year bond has been negative for almost two months, a reflection of the 10-year rate trading well below its 3-month counterpart, and was around minus 61 basis points on Tuesday. Such investments have preceded eight of the last eight recessions. The counterpart spread between 2- BX:TMUBMUSD02Y and 10-year returns BX:TMUBMUSD10Y it has been consistently below zero for nearly six months, though it has given at least one false signal in the past, according to Harvey.

In an interview with MarketWatch, Harvey, a Canadian-born economist, said one reason for his current view is that the 3-month/10-year spread as a model “is so well known by now that it has affected behavior,” causing so much businesses like consumers become more cautious, a form of “risk management” that “makes the likelihood of a soft landing more likely.”

“We are in a period of slow growth, which is consistent with the model, but when it comes to the recession, I am skeptical. A hard landing is unlikely,” he said by phone, though he did not rule out the possibility of a mild recession. “What I am saying is simple. This is a valuable indicator and I believe it is accurate in forecasting slowing economic growth. In terms of a crash landing, you need to look for other information.”

Treasury spreads should generally widen and slope up, not down, as investors take into account brighter growth prospects and seek additional compensation for holding a bond or note for a longer period. They have been falling below zero, or reversing, as the Federal Reserve continues to raise interest rates and investors factor in the likely impact of those moves going forward.

On October 26, the 3-month/10-year spread ended the US trading session below zero for the first time since March 2, 2020. At that point, Harvey said that he would need the spread to close. stay below zero until December to be sure a recession is on the way. He still hasn’t reached that mark, with less than two weeks left in the year.

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

• Unusual employment situation. While unemployment is low before every recession, it is unusual to have as much excess demand for labor as the US does now. “This means laid-off workers can find jobs quickly.”

• Technology-driven layoffs. Laid-off workers from companies like Meta Platforms Inc. META,
  +1.82%,
  the father of Facebook and Twitter “are highly skilled and have very short duration of unemployment,” in contrast to the global financial crisis of 2007-2008 and the brief COVID recession of 2020, which trapped a broader set of workers from other industries.

• Strong consumers and financial institutions. Consumers and the financial sector are stronger than before. That makes it less likely that a drop in house prices would cause contagion, or that any trouble in the financial sector could quickly spread to the entire economy, Harvey said.

• Returns adjusted for inflation. Harvey focuses on inflation-adjusted returns because they better reflect actual economic prospects. “Once we adjust for inflation, the yield curve doesn’t invert, but it is flat (associated with lower growth but not necessarily a recession),” he said.

• Behavior adjustments. Because of the inverted yield curve, companies are unlikely to “bet company” on a big investment project, plus consumers are being cautious and have deep savings, according to Harvey. “All of this leads to a self-fulfilling prophecy, that is, to lower growth. However, you can also view it as risk management. Even if growth slows, companies can get by without mass layoffs.”