What a Yield-Curve Inversion Really Says About the U.S. Economy

Well, guess what, folks? It’s still rainbows and pots of gold out there. Contrary to what seems to have become the overnight conventional wisdom in politics, a recession before Election Day 2020 remains a less than 50-50 proposition. In a Bloomberg survey of economists, the median estimate of the probability of a U.S. recession within the next year is 35%. Back in February, 52% of economists surveyed by the National Association for Business Economics expected a recession by the end of 2020. In the latest edition, released on Aug. 19, that figure was down to 40%.

Far from a downturn, the median forecast for 2020 in Bloomberg’s survey of economists is for growth of 1.8%, which is smack within the range that the Fed estimates the economy can sustain without an acceleration of inflation. If recession isn’t so likely after all, it means the White House probably should ease off on emergency measures to boost growth. And it means the Democrats running for president need to calibrate their messages for a world in which the economy remains strong right up to Election Day 2020.

But what about the inversion of the yield curve that your annoying brother-in-law keeps yammering about? The notion that the U.S. economic expansion will continue, extending what’s already the longest growth streak on record, going back to 1854, seems to fight the news that the famous yield curve has inverted, with long-term interest rates sinking below short-term ones. (The reverse of the usual relationship.) Such inversions have been strong indicators of recessions in the past.

The first thing to say is that the famous inversion between 2-year and 10-year Treasuries is over, at least for now, having lasted all of 2 hours and 15 minutes in the early morning of Aug. 14, according to Bloomberg data. A very brief inversion is less of a recession omen than a long one would be. True, the inversion between 3-month Treasury bills and 10-year notes has been in place most of the time since May, but that’s not as strong an indicator.

The second thing is that any inversion of the yield curve is a less reliable signal of recession now than it was in the past. A few words of background on the yield curve in case you’ve been tuning out your brother-in-law. It’s simply a graph of interest rates. On the left are short-term rates and on the right are long-term rates. The graph slopes up to the right when long-term rates are higher than short-term ones, as they usually are. The extra interest on, say, a 30-year bond compensates investors for the risk that something unpredictable will happen in the next 30 years that damages the bond’s , such as a burst of inflation.

But the yield curve has gotten flatter over the past few decades. So it’s pretty close to sloping downward—i.e., inverting—even on ordinary days when nothing special is happening. It will invert more often “even if the risk of recession has not increased at all,” said an economic note published by the Federal Reserve Bank of Richmond in December.

The upward slope of the yield curve is an artifact of times past, when the rate of inflation was higher and—importantly—less predictable than now. Long-term bonds had to offer high yields to attract investors to compensate for the fact that they were a poor hedge against the biggest worry of the day, namely an unexpected spike in inflation. These days, though, the biggest worry is not inflation but deflation. Bonds happen to be an excellent hedge against deflation because they gain in when interest rates fall.

This is a roundabout way of explaining why the inversion of the yield curve—so famous that even Trump tweets about it—isn’t as worrisome as it once was. Long-term bonds have become more useful in reducing the risk in an investor’s portfolio than they were 40 years ago, so they don’t have to offer such high yields to attract buyers. As a result, the famous upward slope of the yield curve has mostly disappeared, and an inversion “is less likely to be a predictor of recession than it used to be,” says Alexander Wolman, an economist and vice president at the Richmond Fed who was the lead author of the bank’s paper on the shape of the yield curve.

There’s plenty of evidence of U.S. economic strength outside the bond market as well. At just 3.7% in July, the unemployment rate is down to levels not seen since the 1960s. That’s good not only for newly employed workers, who have been pulled off the sidelines, but also for the businesses that sell things to them. Consumer spending, the biggest part of the economy, expanded at an annual rate of 4.3% in the second quarter. (It would be even stronger if rich retirees overcame their fear of spending some of their ample savings.) In times past, ultralow unemployment would have stirred fears of excessive inflation. But the inflation measure that the Fed pays attention to, the price index for personal consumption expenditures, rose just 1.4% over the past year. That’s below the Fed’s 2% target.

Another big plus for U.S. growth is fiscal policy, which is amplifying the demand for goods and services. The federal deficit as a share of gross domestic product got as small as 2.2% near the end of President Obama’s time in office in 2016, but has since grown to 4.5% because of tax cuts and spending increases. Critics argue that this isn’t the right time in the business cycle for highly expansionary fiscal policy, but the fact remains that it’s keeping a fire under the economy, says Jim Paulsen, chief investment strategist of Leuthold Group LLC in Minneapolis.

Interest rates are becoming more supportive of growth, too. Earlier this year the Fed stopped raising rates after nine quarter-point increases. In July it cut by a quarter point, and the market anticipates two or three more reductions this year—with or without Trump’s exhortations. Unlike most of the industrialized world’s central banks, the Federal Reserve still has plenty of room to cut rates before getting down to zero.

Better yet, interest rates in the U.S. at the long end of the yield curve are down sharply. The yield on the 10-year Treasury note is down by half since November to under 1.6%. (That’s the inversion story again.) While the decline in long rates tends to be viewed as a sign investors expect slower economic growth, the low rate itself boosts growth by encouraging more borrowing by consumers and businesses. Meanwhile in stocks, the S&P 500 is still up almost 17% this year despite recent jitters.

American banks were weak heading into the last recession. Now they have healthier cushions of capital and ample liquidity, meaning they can easily meet demands on their money, Lena Komileva, chief economist of G+ Economics in London, wrote in a note to clients on Aug. 16.

True, the rest of the world is weaker than the U.S., but that doesn’t mean the U.S. is certain to be dragged down by recessions or slumps elsewhere. Other countries could rebound. “There is room for fiscal support from the likes of Germany and South Korea,” and “China still has powerful tools to support credit growth and manage its deceleration,” Christopher Smart, chief global strategist and head of the Barings Investment Institute, wrote in an Aug. 19 note to clients.

More important, the U.S. remains relatively insulated from troubles abroad. Because its domestic market is the world’s biggest, companies don’t depend heavily on exports for growth. Only in Sudan, Burundi, Cuba, and Nigeria is trade a smaller share of GDP, according to World Bank data.

America’s inwardness is also why Trump’s trade war with China hasn’t done more damage. U.S. exports to China are just over $150 billion a year. Even if they fall by a quarter, that would cut U.S. GDP by only 0.2%.

All that said, the risk of a recession can’t simply be dismissed. Fear of a worsening trade war, for example, could trigger a generalized pullback in U.S. business investment. “Our analysis suggests the tweet is mightier than the tariff, with a bigger negative impact from uncertainty than the protectionist measures themselves,” economists from Bloomberg Economics wrote on Aug. 19. They estimate that uncertainty generated by the trade war could cut 0.6% from U.S. output by 2021 vs. a no-trade-war scenario, while the direct impact of current and scheduled tariffs will cut just 0.3%. The impact of the tensions is already being felt worldwide: Since trade tensions began rising in early 2018, the JPMorgan Chase & Co. purchasing managers’ index for global manufacturing has fallen from 54.4 (robust expansion) to 49.3 (mild contraction), the Bloomberg Economics team pointed out.

The biggest risk is that business will perceive that the trade war presages an end to globalization, which Komileva of G+ Economics wrote “will turn some economic activity unproductive and cut off businesses from credit, at any level of central bank rates, especially where global economic links run deepest.”

Consumer confidence is another potential trouble spot. The University of Michigan’s consumer sentiment index fell in August to a seven-month low. Bank of America Corp. Chief Executive Officer Brian Moynihan echoed President Franklin Roosevelt in a Bloomberg Television interview on Aug. 16, saying, “We have nothing to fear about a recession right now except for the fear of recession.”

The Federal Reserve could put a smile back on investors’ faces by whacking half a point off the federal funds rate at its September meeting, instead of making the expected quarter-point cut, says Leuthold Group’s Paulsen. Investors could use the reassurance of a big cut even if the economic fundamentals don’t justify it, he says. “The risk we have is the economy may be great, but if you scare the private sector enough, they’ll stop doing everything and we’ll free-fall,” says Paulsen. A recession that struck now would be hard to fight because fiscal and monetary policy are already stimulative.

Which leads us back to Trump, who’s made his stewardship of the U.S. economy his No. 1 issue. “The strong economy is Trump’s best message and it is the one that has the broadest appeal and offers the best chance to increase his support base,” says Republican strategist Matt Mackowiak. To put it differently, a recession would doom the reelection bid of a president who, even with today’s robust economy, can’t get his approval numbers much above 40%.

That helps explain his all-out campaign to keep the economy moving, including his Aug. 19 tweet that the Fed under Chair Jerome Powell should cut the federal funds rate by at least a full percentage point “over a fairly short period of time.”

Trump knows he’s divisive, but he’s banking on voters to reward him for presiding over the latter stage of what’s become the longest economic expansion in U.S. history. “You have no choice,” he told voters at a rally in New Hampshire on Aug. 16. “Whether you love me or hate me, you gotta vote for me.” If economic conditions continue to be favorable, he just might get what he wants. —With Jordan Fabian

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