Erik Norland, CME Group
IN ONE LOOK
- Although it doesn’t meet the technical definition of a recession, a June YouGov poll showed that 58% of Americans believed the economy was already in a slump.
- Neither of the two fixed-income-based indicators of future economic activity – the yield curve and credit spreads – point to a near-term recession.
The word recession is popping up more and more frequently in news and internet searches. Google Trends shows searches for the word have jumped 25-fold over the past six months, as a June 20 YouGov poll showed 58% of Americans believed the economy was already in a recession. Only 19% disagreed.
Indeed, with prices rising 9.1% year over year and outpacing wage growth, it may feel like a recession for those who feel their purchasing power is eroding. Even so, it still does not meet the technical definition of a recession, which equates to two consecutive quarters of negative growth. In the first quarter of 2022, GDP fell by 1.6% at an annualized rate compared to the fourth quarter of 2021, but it increased by 3.5% compared to the first quarter of 2021. The reason why the growth of a quarter to the other was negative in the first quarter of 2022 was largely due to lower inventories. , imports increased and government spending declined. Other key sectors, including business investment and personal consumption, continued to grow. Moreover, the drop in inventories in the first quarter may portend a subsequent rebound in the coming quarters, as these inventories may be replenished.
So far in 2022, job growth has remained robust. Other indicators such as purchasing manager surveys show a moderate pace of growth, but this growth remains positive. The Conference Board’s consumer confidence survey shows that Americans assess the current state of the economy quite favorably and that their concerns are mainly about the future.
When it comes to looking at the future of the economy, fixed income investors have one of the best historical track records. There are essentially two fixed income-based indicators of the future direction of economic activity:
1. The yield curve: The difference between long-term and short-term rates can be a useful indicator of where the economy is going in six to 24 months.
2. Credit spreads: The difference between high-yield corporate bonds and US Treasuries of equivalent maturities can be a great indicator of where the economy is going in the coming months.
For now, bond markets are not signaling a recession on the immediate horizon. The yield curve in the United States remains moderately steep. Before almost every previous recession, the yield curve inverted, meaning that short-term rates rose above the level of long-term rates. For example, yield curves inverted before the recessions of 1980, 1981-82, 1990, 2001, 2008-09, and 2020.
Although some segments of the yield curve have inverted at various times over the past few months, we have not had a full 3M10Y reversal. However, a yield curve inversion is an imminent possibility, especially if the Fed continues to hike rates aggressively.
At the end of June, the Treasury yield curve still showed 150 basis points (bp) of positive slope. The private sector curve, 10-year swaps minus 3-month LIBOR, is slightly less steep, with a positive slope of 96 basis points at the end of June, and it has a better track record of forecasting accelerations and decelerations in the pace of economic growth.
The main conclusion, however, is that if the Fed raises rates enough to invert the yield curve, it might not imply a near-term recession. In the 20 years from 1999 to 2019, yield curves reached their maximum correlation with future growth about a year and a half to two years into the future. Thus, a yield curve inversion at the end of 2022, if it occurs, might not suggest a high likelihood of a recession before the end of 2024. Finally, there have been times when yield curves have steepened. briefly reversed, but the reversal was not followed by a real slowdown. Thus, the curve may need to remain inverted for several months before the risk of recession really begins to increase.
Second, and perhaps more importantly in the short term, credit spreads are not yet signaling the onset of an economic downturn. Granted, credit spreads have widened as equities have begun to sell off but, at the time of this writing, high yield bonds are trading at yields of around 5.8% relative to Treasury of equivalent maturity. Prior to past recessions, these spreads typically widened to around 6-10% or more on Treasuries and remained there for many months. Brief spikes in spreads occurred in 2011 and 2015 with no subsequent recessions. Such widening of spreads, however, could happen quickly if stocks continue to sell off.
Our US employment model shows that in the 24 years before the pandemic, credit spreads alone explained more than 60% of the monthly variation in nonfarm payrolls. The current spread between high-yield corporate bonds and US Treasuries suggests job growth of around 150,000 per month in the coming months. In our model, credit spreads must widen to more than 7% before monthly employment growth tends to turn negative. Payroll growth of 150,000 a month is much slower payroll growth than in recent months, but with the U.S. economy back close to full employment, that could be close to the limit of what the US economy can handle.
With high inflation, it’s clear that consumers in the United States and many other countries are concerned about the economy. It is important to point out, however, that in 2022 the economy essentially has the opposite problem to the one it had after the 2008 financial crisis. Back then, demand was too weak, there was no not enough jobs for everyone and deflation was the major risk. Today the economy is overheating, there is too much money for too few goods and there are more jobs to offer than there are workers to fill them. It is as if the economy has gone from hypothermia in 2009 to a fever in 2022. The challenge for policymakers will be to bring the economic temperature down enough to create a soft landing without reducing it too much and making recession a reality.