We have written at length in the past about the yield curve’s historically reliable track record of predicting recessions. Yield curve inversions preceded all of the 8 recessions that the US economy has experienced over the past 60+ years. Such predictive ability is explained by the yield curve being a proxy of monetary policy, with inversions signaling restrictive conditions. Based on the spread between the 10-year and the 3-month Treasury yield, the length of time between inversion and subsequent recession has ranged between 5.8 months (1973) and 17.3 months (2006-2008), averaging 11.3 months. If we disregard inversions smaller than 10 bps as immaterial, the only false signal occurred in 1966, a rare example of a soft landing. Back then, roughly 200 bps of rate cuts over the 9 months immediately following the yield curve inversion were just enough to stimulate a slowing economy and prevent a full-blown recession.
It has currently been 19.7 months since the latest yield curve inversion, which occurred in November 2022, and the curve remains inverted as of today. Despite some signs of slowing recently, so far the economy has been incredibly resilient thanks to certain features of the COVID-19 recession and subsequent recovery that effectively contributed to insulating the economy from higher interest rates:
- Generous stimulus checks paid out during the pandemic resulted in households accumulating $2.1 trillion of excess savings (i.e. savings in excess of the pre-pandemic trend), which then fueled a wave of consumer spending that was relatively insensitive to higher interest rates since it didn’t require borrowing.
- Both businesses and households were able to take advantage of record-low interest rates by refinancing and extending their existing debt, thereby locking in those record-low rates for years to come.
- The pandemic created structural labor shortages across the economy which resulted in an unusually tight labor market and fast rising wages, especially for lower-income cohorts which have the highest propensity to spend rather than save.
The issue is that, just like with vaccines, the immunization effect from these factors will not last forever, and in fact it appears to be waning. At this point, those $2.1 trillion of excess savings appear to have been fully spent, as evidenced by rising credit card usage and delinquency rates. Some fraction of the outstanding corporate debt is coming due and needs to be refinanced at much higher rates. And, the job market finally appears to be softening. For now, the economy appears to be slowing in a gradual and benign fashion, consistent with a soft landing scenario. However, with the Fed’s inflation target now in sight, we think Powell & Co. need to get on with it and start cutting rates sooner rather than later. The longer they stay put, the higher the risk that the inverted yield curve will end up taking a toll on an economy that is losing its immunity from high interest rates. The market currently sees a 73% chance of a rate cut in September. We would take the over.
Source: CWA, Bloomberg, as of 6/30/2024
Source: CWA, Bloomberg, as of 6/30/2024
Sauro Locatelli CFA, FRM®, SCR®
Director of Quantitative Research
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