Predicting the Next Recession and Other Ways to Waste Your Time

The people who completely missed the housing bubble, the collapse of which sank the economy in 2008 and gave us the Great Recession, are again busy telling us about the next recession on the way. The latest item that they want us to be very worried about is an inversion of the yield curve. There has been an inversion of the yield curve before nearly every prior recession and we have never had an inversion of the yield curve without seeing a recession in the next two years.

If you have no idea what an inversion of the yield curve is, that probably means you’re a normal person with better things to do with your time. But for economists, and especially those who monitor financial markets closely, this can be a big deal.

An inverted yield curve refers to the relationship between shorter- and longer-term interest rates. Typically, a longer-term interest rate, say the interest rate you would get on a 30-year bond, is higher than what you would get from lending short-term, like buying a three-month Treasury bill.

The logic is that if you are locking up your money for a longer period of time, you have to be compensated with a higher interest rate. Therefore, it is generally true that as you get to longer durations, say a one-year bond compared to three-month bond, the interest rate rises. This relationship between interest rates and the duration of the loan is what is known as the “yield curve.”

We get an inverted yield curve when this pattern of higher interest rates associated with longer-term lending does not hold, as was at least briefly the case last week. For example, on Wednesday, March 27th, the interest rate on a three-month Treasury bill was 2.43 percent. The interest rate on a ten-year Treasury bond was just 2.38 percent, 0.05 percentage points lower. That meant that we had an inverted yield curve.

While this sort of inversion has historically been associated with a recession in the not too distant future, this is not quite a curse of an inverted yield curve story. Most recessions are brought on by the Federal Reserve Board raising the overnight federal funds rate (a very short-term interest rate), which is directly under its control. The Fed does this to slow the economy, ostensibly because it wants to keep the inflation rate from rising.

The higher short-term rate tends to also raise long-term interest rates, like car loans and mortgages, which are the rates that matter more for the economy. However, longer-term rates tend not to rise as much as the short-term rate. In a more typical economy, we might expect a 3.0 percentage point rise in the federal funds rate to be associated with a 1.0–2.0 percentage point rise in the ten-year Treasury bond rate.

We get an inversion in this story when the Fed goes too far, or at least investors in the bond market think it has gone too far. The Fed keeps raising the short-term rate, but investors in longer-term debt think that they see an end in sight to rate hikes and a reversal on the way. If the short-term rate is going to be falling to 2.0 percent or even lower in future months, then investors would welcome the possibility of locking in an interest rate like today’s 2.38 percent on ten-year bonds, even if it means foregoing a slighter higher short-term rate at the moment.

That’s pretty much the story we have today. Since December of 2015, the Fed has raised the federal funds rate from essentially zero to 2.5 percent. With little evidence of inflation and some signs of a weakening economy, many investors are betting that the Fed has stopped hiking rates and will soon be lowering them. This hardly means there we will necessarily be seeing a recession.

It is also worth noting that interest rates in the US are notably higher than in other countries, which do face a recession or near recession conditions. While the US ten-year Treasury bond pays 2.38 percent interest, a ten-year French bond pays just 0.31 percent. In the Netherlands the interest rate is 0.13 percent, and in Germany, you have to pay the government 0.07 percent annually to lend them money.

These extraordinarily low long-term interest rates in other countries puts downward pressure on interest rates here. Getting 2.38 percent interest on a ten-year Treasury bond may not sound very good by historical standards, but it is a lot better than having to pay the German government to borrow your money. This is another factor in our inverted yield curve.

Of course the weakness of foreign economies is bad news for the U.S. economy. Weakness in Europe, a weaker Chinese economy, and Canada possibly seeing the implosion of its housing bubble, means that trade will likely be a drag on growth in 2019 and probably 2020, as the trade deficit rises further. But, slower export growth is not going to be sufficient to push the U.S. economy into recession.

To be clear, the signals all point to a considerably weaker economy going forward. The Trump tax cut gave us a one-time boost. It was not the promised investment boom that lifted growth in 2018. Investment grew modestly, rather it was a story where the wealthy people — who were the main beneficiaries of the tax cut – spent much of the money they got either directly or indirectly as share buybacks and dividends.

This led to a jump in consumption in 2018, but with no further tax cuts on the horizon, we can assume that consumption will return to its modest growth path of pre-recession years. Investment has been weakening, but presumably will be a modest positive through the year. On the other hand, housing is being hit by higher interest rates and is likely to be a drag on growth.

The drag from housing and trade could well push growth below the 2.0 percent trend path we had been on through most of the recovery. The weakness can be amplified if the Republicans’ new found (post-tax cut) concern with deficits, combined with austerity minded Democrats, leads to cuts in federal spending.

However, with wages growing at a respectable pace, and job growth remaining healthy, we should see still see enough consumption demand to keep the economy moving forward. That means slower growth, but no recession.

One story we can rule out is a collapse of the corporate bond market leading to another 2008 financial crisis and recession. The New York Times has been running regular columns from former investment banker William Cohan telling us the corporate debt bubble story (here, here, and here).

As I’ve pointed out many times, the corporate debt market does not move the economy in the same way as the housing bubble did before 2008, and therefore its collapse cannot possibly lead to the same sort of downturn. The housing bubble was both directly moving the economy through an unprecedented boom in residential construction and indirectly through the wealth effect on consumption. People were borrowing against their homes and spending at an unprecedented rate.

When the bubble burst, residential construction collapsed, cutting more than 4.0 percentage points off of GDP (roughly $900 billion annually in today’s economy). The loss of housing wealth led to a plunge in consumption of at least 2 percent of GDP (another $420 billion in annual demand in the 2019 economy).

There is no way that even a major collapse of the corporate bond market could have anywhere near this effect. There is no investment boom, so the impact on investment of some companies being unable to issue bonds or otherwise borrow money is likely to be trivial.

The same applies to any secondary spillover on consumption. We are not now seeing any sort of consumption boom. In an extreme case, where we see a $1-$2 trillion plunge in the value of corporate debt, the ultimate impact on consumption is almost certain to be in the low tens of billions, perhaps a loss of 0.1 or 0.2 percent in annual demand. That is not the stuff of recessions.

Before the Great Recession the New York Times had problems finding people who understood the risks of bubbles to write for them. It seems to still have this problem.

Anyhow, the long and short here is that people need not spend time worrying about the curse of the inverted yield curve. At least not unless something else bad happens, there is not a recession on the horizon.

Enjoy the spring weather!

More articles by:

Dean Baker is the senior economist at the Center for Economic and Policy Research in Washington, DC. 

August 22, 2019
George Ochenski
Breaking the Web of Life
Kenneth Surin
Boris Johnson’s Brexit Helter Skelter
Enrique C. Ochoa – Gilda L. Ochoa
It’s About Time for Ethnic Studies in Our K-12 Schools
Steve Early
A GI Rebellion: When Soldiers Said No to War
Clark T. Scott
Sanders And Bezos’s Shared, Debilitating, Basic Premise
Dan Corjescu
The Metaphysics of Revolution
Mark Weisbrot
Who is to Blame for Argentina’s Economic Crisis?
Howard Lisnoff
To Protect and Serve
Cesar Chelala
A Palestinian/Israeli Experiment for Peace in the Middle East
Binoy Kampmark
No Deal Chaos: the Brexit Cliff Face and Operation Yellowhammer
Josue De Luna Navarro
For True Climate Justice, Abolish ICE and CBP
Dean Baker
The NYT’s Upside Down Economics on Germany and the Euro Zone
August 21, 2019
Craig Collins
Endangered Species Act: A Failure Worth Fighting For?
Colin Todhunter
Offering Choice But Delivering Tyranny: the Corporate Capture of Agriculture
Michael Welton
That Couldn’t Be True: Restorying and Reconciliation
John Feffer
‘Slowbalization’: Is the Slowing Global Economy a Boon or Bane?
Johnny Hazard
In Protest Against Police Raping Spree, Women Burn Their Station in Mexico City.
Tom Engelhardt
2084: Orwell Revisited in the Age of Trump
Binoy Kampmark
Condescension and Climate Change: Australia and the Failure of the Pacific Islands Forum
Kenn Orphan – Phil Rockstroh
The Dead Letter Office of Capitalist Imperium: a Poverty of Mundus Imaginalis 
George Wuerthner
The Forest Service Puts Ranchers Ahead of Grizzlies (and the Public Interest)
Stephen Martin
Geopolitics of Arse and Elbow, with Apologies to Schopenhauer.
Gary Lindorff
The Smiling Turtle
August 20, 2019
James Bovard
America’s Forgotten Bullshit Bombing of Serbia
Peter Bolton
Biden’s Complicity in Obama’s Toxic Legacy
James Phillips
Calm and Conflict: a Dispatch From Nicaragua
Karl Grossman
Einstein’s Atomic Regrets
Colter Louwerse
Kushner’s Threat to Palestine: An Interview with Norman Finkelstein
Nyla Ali Khan
Jammu and Kashmir: the Legitimacy of Article 370
Dean Baker
The Mythology of the Stock Market
Daniel Warner
Is Hong Kong Important? For Whom?
Frederick B. Mills
Monroeism is the Other Side of Jim Crow, the Side Facing South
Binoy Kampmark
God, Guns and Video Games
John Kendall Hawkins
Toni Morrison: Beloved or Belovéd?
Martin Billheimer
A Clerk’s Guide to the Unspectacular, 1914
Elliot Sperber
On the 10-Year Treasury Bonds 
August 19, 2019
John Davis
The Isle of White: a Tale of the Have-Lots Versus the Have-Nots
John O'Kane
Supreme Nihilism: the El Paso Shooter’s Manifesto
Robert Fisk
If Chinese Tanks Take Hong Kong, Who’ll be Surprised?
Ipek S. Burnett
White Terror: Toni Morrison on the Construct of Racism
Arshad Khan
India’s Mangled Economy
Howard Lisnoff
The Proud Boys Take Over the Streets of Portland, Oregon
Steven Krichbaum
Put an End to the Endless War Inflicted Upon Our National Forests
Cal Winslow
A Brief History of Harlan County, USA
Jim Goodman
Ag Secretary Sonny Perdue is Just Part of a Loathsome Administration