An Impending Shift in a Recession Marker?
Second quarter real GDP growth was 4.2% on an annualized basis and the Atlanta Fed's GDPNow Model is estimating 4.1% real GDP growth for the third quarter.
That is strong growth. Why, then, is everyone caught up in discussing the next recession?
There are several reasons:
- It is thought by many that we are in the late stages of the economic expansion.
- There are worries that the Federal Reserve will raise interest rates too much and kill the expansion.
- Growth in other developed economies is flagging.
- Protectionist trade practices are on the rise and it is feared the U.S. and China -- the world's two largest economies (excluding the EU bloc) -- are headed for a protracted trade war.
- Copper prices, which are considered an important leading indicator, have declined 19.0% since early June.
We suppose one could find other reasons to cite, yet the road to any recession conversation almost always leads back to the U.S. Treasury market and the shape of the yield curve.
A Different View
The focal point for market participants is the spread between the 10-year Treasury note and the 2-year Treasury note.
This past April we published a The Big Picture piece that highlighted the narrowing spread between the two Treasury securities and pointed out that each of the five recessions that have occurred since 1980 happened when the spread has inverted. The spread being inverted occurs when the short-term rate is higher than the long-term rate.
The past recessions haven't been an instantaneous reaction to this yield curve behavior. The average time between the first inversion and those recessions has been just over 18 months, with a range that has spanned ten months to two years.
The stock market, however, will begin to recalibrate before the contraction occurs, which is in keeping with its forward-looking mindset.
Accordingly, with the S&P 500, Nasdaq Composite, and Russell 2000 all hitting new record highs in the past week, there is a burgeoning sense that the narrowing spread between the 10-yr note and the 2-yr note, which sits at just 20 basis points, isn't as foreboding as it seems.
St. Louis Fed President James Bullard doesn't seem to be leaving anything to chance. He feels the Federal Open Market Committee (FOMC) would be wise to heed that flattening and volunteered that, if it were up to him, he would not be raising interest rates.
The FOMC, by the way, is widely expected to raise the target range for the fed funds rate again at its September 25-26 meeting.
Bullard said his position is rooted in the understanding that inflation is not a problem now and that he doesn't want to see a repeat of the past when Alan Greenspan and Ben Bernanke both pooh-poohed the yield curve signal in 2000-2001 and 2006, respectively, and got it wrong.
Researchers at the San Francisco Federal Reserve, however, published a paper recently that gave the stock market reason to think calls for the death of the economic expansion emanating from the 10Yr-2Yr spread are still greatly exaggerated.
A Better Measure
To be clear, the opinions expressed in the FRBSF Economic Letter1 don't necessarily reflect the views of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.
The opinions, though, are quite pertinent to the market conversation.
While the research acknowledges the validity of the yield curve as a reliable predictor of recessions, the main takeaway for our purposes here is that the spread between the 10-yr note yield and the 3-month T-bill yield is the most reliable predictor of recession among the different term spreads.
Why is that finding important?
Because the spread between the 10-yr yield and the 3-month yield is 72 basis points, whereas, the spread between the 10-yr yield and the 2-yr yield is just 20 basis points.
Both spreads are down sharply from five years ago and they aren't trending in the most uplifting manner. Nevertheless, for a bull market that wants to find more reason to run, the added cushion provided in the 10Yr-3Mo spread could be one such reason.
The question is, will the stock market cede the first right of recession warning to the 10Yr-3Mo spread or the 10Yr-2Yr spread?
The Economic Letter points out that it has been the tradition in the academic literature to focus on the 10Yr-3Mo spread when it comes to pegging a recession indicator while financial commentators typically emphasize the 10Yr-2Yr spread.
What It All Means
We can't dismiss the possibility that the Economic Letter had some bearing on the stock market's positive performance in the final week of August, which wrapped up a great month for the stock market.
There were other news catalysts and our supposition is only based on anecdotal evidence, which included the outperformance of the cyclical sectors.
Even so, the Economic Letter carried a tone that suggested it is still premature to get carried away with recession calls, because (a) there isn't a term spread across the yield curve that is inverted and (b) the spread of the most reliable recession predictor is still a good bit away from inverting.
That's not to say the stock market won't act a little finicky if/when the 10Yr-2Yr spread inverts, yet it has been thrown a recession lifeline, so to speak, by this Economic Letter, which highlights the inversion of the 10Yr-3Mo spread as the more reliable recession predictor.
The stock market's ability to look past an inverted 10Yr-2Yr spread, and to defer to a positive 10Yr-3Mo spread, will have a lot to do with what is going on around it at the time that spread inverts.
Recession calls will pick up if the 10Yr-2Yr spread inverts, but for a bull market that has managed to bypass worst-case scenarios time and time again, don't be surprised if it starts looking to the 10Yr-3Mo spread as its preferred yield-curve marker.
1Bauer, Michael D., and Thomas M. Mertens. 2018. "Information in the Yield Curve about Future Recessions." FRBSF Economic Letter 2018-20 (August 27).
About Patrick O'Hare
Patrick O'Hare Archive
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