For months, the bond market has sounded many warnings that a US recession could be on the way, a view that many in financial markets have finally accepted.
One of them is the 10-year minus 3-month Treasury yield, which has been below zero since late October but has not been negative long enough to send a definitive signal about an impending economic downturn. Now Campbell Harvey, a Duke University finance professor who pioneered the use of the spread as a predictive tool, says the gauge can send “a false signal, which is interesting because I’m the one who invented the indicator.”
Harvey’s surprising conclusion, which in 1986 dissertation at the University of Chicago linked the difference between long-term and short-term interest rates to future U.S. economic growth, comes at a time when the broader financial market is worried about a possible economic downturn. in 2023
Tuesday US stocks DJIA,
managed to recover from four consecutive declines as investors weighed recession fears and a surprise policy shift by the Bank of Japan. In the bond market, 41 different yield spreads were negative as of Tuesday, according to Dow Jones Markets, a sign of pessimism about the economic outlook.
TMUBMUSD03M Spread between 3-month bill interest rates,
and the 10-year note has been negative for nearly two months, reflecting the 10-year rate trading well below its 3-month counterpart, and ended the New York session on Tuesday at minus 66.3 basis points. Such inversions have preceded eight of the past eight downturns. 2- The spread between BX:TMUBMUSD02Y and 10-year yields BX:TMUBMUSD10Y has been consistently below zero for nearly six months, although it has issued at least one false signal in the past, according to Harvey.
In an interview with MarketWatch, Harvey, a Canadian-born economist, said one of the reasons for his current view is that the 3-month/10-year spread as a model is “so popular now that it has influenced behavior,” causing: both companies and consumers to become more cautious, a form of “risk management” that “makes the likelihood of a soft landing more likely.”
“We’re in a period of slow growth, which fits the model, but as for a recession, I’m skeptical about that. A hard landing is unlikely,” he said by phone, though he did not rule out the possibility of a soft landing. “What I am saying is clear. This is a valuable indicator, and I believe it is accurate in predicting a slowdown in economic growth. In terms of hard landing, you need to look at other information.”
Typically, Treasury spreads should widen and tilt upward, not downward, as investors factor in brighter growth prospects and seek additional compensation for holding a longer-dated bond or note. They have been cut below zero or reversed as the Federal Reserve continues to raise interest rates and investors factor in the likely impact of those moves.
On October 26, the 3-month/10-year spread ended the US trading session below zero for the first time since March 2, 2020. At the time, Harvey said he should see the spread stay below zero until December. rest assured that a recession is on its way. It hasn’t reached that mark yet, with less than two weeks left in the year.
That’s why the professor now cites why the spread may not be such a reliable indicator of an impending recession this time around, even though it clearly points in the direction of “lethargic” economic growth;
Unusual work situation. While unemployment is low before every recession, it is unusual to have as much excess demand for labor as the US has now. “This means that laid-off workers can find work quickly.”
Technology-based layoffs. Laid-off workers from companies such as Meta Platforms Inc. META,
The parents of Facebook and Twitter are “highly skilled and have very short periods of unemployment,” unlike the global financial crisis of 2007-2008 and the short-lived COVID downturn of 2020, which attracted a wider range of workers from other industries.
Strong consumers and financial institutions. Consumers and the financial sector are stronger than ever. That makes it less likely that a decline in housing prices will be contagion, or that any problems in the financial sector can spread quickly through the economy, Harvey said.
Inflation-adjusted return. Harvey focuses on inflation-adjusted returns because they better reflect the real economic outlook. “When inflation adjusts yields, the yield curve is not inverted, but it is flat (associated with lower growth but not necessarily recession),” he said.
Behavioral adjustments. Because of the inverted yield curve, companies are unlikely to “bet the company” on a large investment project, plus consumers are cautious and have plenty of savings, according to Harvey. “All of this leads to a self-fulfilling prophecy, ie lower growth. However, you can also look at it as risk management. Even if growth slows, companies can cope without massive layoffs.”