Looming recession seen in US

Abnormal yield curve, loss of confidence, negative GDP growth among bad omens

While politicians debate whether the United States is in a recession or not, a long-followed metric closely tracked by investors in and out of Wall Street suggests the economy could weaken in the weeks and months ahead.

That metric is the Treasury yield curve, and investors are watching out for an inverted yield curve, which takes place when short-term rates are higher than long-term rates.

Investors who put their money in a 10-year Treasury instrument instead of a two-year note may be indicating they do not have confidence in the economy’s overall health.

The Federal Reserve has raised interest rates by 225 basis points to fight inflation this year, which has sent the two-year Treasury yield almost 50 basis points above the 10-year note.

That is the deepest inversion since 2000. The inversion retreated to 40 basis points from 50 on Wednesday after softer-than-expected inflation data for July, Jamie McGeever, a capital markets columnist for Reuters, said on Wednesday.

Inversions happen when investors sell stocks and shift their cash to bonds. Their thinking is that smaller, guaranteed returns from bonds might exceed what they could lose by owning stocks going into a recession. Higher demand for bonds results in lower yields.

Precedents in history

“This widespread loss of confidence explains why inverted yield curves have preceded every recession since 1956,” according to CNBC.

The last inversion began in December 2005 and preceded the recession which officially began in December 2007, followed by the 2008 global financial crisis. There was also an inversion in yields before the tech bubble burst in 2001.

On Mar 31, the two-year and 10-year yields inverted for the first time since 2019.

Recessions do not begin right after an inversion. Historically, an inversion tends to precede the recession by an average of six to 18 months.

Inflation is at a four-decade high. While the consumer price index ebbed in July, registering an 8.5 percent increase year-on-year, US equity markets have had their worst six-month start since 1970 in the first half of 2022.

The lower rise in inflation announced on Wednesday, however, did spark a rally in the stock market, with the Nasdaq reentering bull market territory.

“The only reason why we are seeing this rally is because of the decline in oil, and that is not a good enough reason. How can that be a good reason? The data we are seeing is that people are driving less than they did last summer. That’s not the kind of signal that gives you more confidence about the economy. It’s the kind of signal that should give you less,” Vladimir Signorelli, head of Bretton Woods Research in New Jersey, told Forbes.

The downward-sloping yield curve will also erode margins and curb bank lending. The economic impact of banks reducing credit to businesses and households is a negative development.

Banks can make money when interest rates rise, but it is easier when the yield curve slopes upward, and they borrow lower and lend higher. A deeply inverted curve dampens margin expansion, a major metric measuring the profitability of companies.

“The slope of the curve matters,” said Christopher Wolfe, managing director of North American Banks at Fitch Ratings in New York.

The Fed’s latest Senior Loan Officer survey shows that a “significant” net 24 percent of banks tightened lending standards for commercial and industrial loans in July.

Morgan Stanley’s Betsy Graseck estimates that the three largest US banks — JP Morgan, Bank of America and Citi — may need to reduce their riskiest assets by more than $150 billion by the end of this year.

The debate is also heated over whether the US economy is already in recession. Gross domestic product growth was negative in the first and second quarters this year, which would meet the traditional definition of a recession.

But many economists say a hot jobs market — average job growth this year is running at almost 500,000 monthly — will lead the National Bureau of Economic Research to refrain from calling the current situation a recession.

“But why is the job market so hot?” asked Peter Earle, a research fellow at the American Institute for Economic Research, in a column for investing website Seeking Alpha on Wednesday. “Doesn’t that clash with notions of an economy in contraction?

“Possibly, but not necessarily,” he answered. “In light of the unprecedented circumstances wrought by lockdowns, stay-at-home orders, and other commercial depressants over the last few years, alternate or contributing explanations deserve consideration.”

He wrote that “most surprising of all is that in July 2022, the number of Americans not only working two jobs, but two full-time jobs, reached a record high”.

“Growing uncertainty may explain the seemingly discordant labor market. The rapid onset of concern over eroding purchasing power, diminishing retirement prospects, and sagging growth may be jolting passivity into action. Individuals may be responding to mounting financial insecurity by securing, improving, or adding to their employment.”

The rapid onset of concern over eroding purchasing power, diminishing retirement prospects, and sagging growth may be jolting passivity into action.”

Depressed demand

Mauro Forlin, an asset manager for financial media group Money-Web, said in a column on Wednesday that some economic signals could be recessionary. He noted how the ISM Manufacturing New Orders Index has been in contraction since June. That index is a signal that shows if companies are beginning to see a slowdown in new orders and demand.

“This moderation in demand growth has led to a buildup in inventory levels, which further implies that companies are struggling to move inventory. We have seen this with big retailers such as Target and Walmart,” said Forlin.

If new orders are falling and inventories are rising, then companies are likely to slow down production, which will ultimately lead to a lower gross domestic product, he said, adding that he also looked at the price of copper, which is used in many industries and products.

When copper prices rise, it indicates strong demand and a growing global economy. When they fall, it suggests depressed demand and an economic slowdown, Forlin explained.

Gold is seen as a defensive precious metal, and its price will generally increase during times of economic uncertainty because it is a safe haven investment.

The copper-to-gold price ratio has plunged, which indicates a deterioration in economic activity globally, he said, although copper also rebounded on Wednesday on the news of a lower US inflation rate.

Peter Earle , a research fellow at the American Institute for Economic Research