Economist "Confused": Why is every leading indicator of a recession failing?

The most favored recession signal on Wall Street began to "flash red" in 2022 and has been ongoing since then, but so far, the recession has not arrived.

Since then, the yield on 10-year U.S. Treasury bonds has been lower than most short-term U.S. bond yields, a phenomenon known as an inverted yield curve, which has occurred before almost every recession since the 1950s.

However, despite the traditional view that an economic recession should occur within a year or at most two years after an inverted yield curve, the United States has not only not experienced an economic recession, but the economy is still growing.

This situation has puzzled many on Wall Street, who want to know why the inverted yield curve, which is both a recession signal and to some extent a recession trigger, is so off this time, and whether it is still a persistent signal of economic danger.

"So far, yes, it has been lying," joked Mark Zandi, chief economist at Moody's Analytics. "This is the first time it has inverted without a recession. But that being said, I don't think we can be comfortable with the continued inversion. It has been wrong so far, but that doesn't mean it will always be wrong."

The U.S. bond yield curve has been inverted since July 2022 (measured by the 2-year yield) or October of the same year (measured by the 3-month Treasury yield). Some even prefer to use the federal funds rate, the rate at which banks lend to each other overnight. This would push the inversion point to November 2022.

Regardless of the chosen time point, an economic recession should have already arrived. The inverted yield curve has only been wrong once in the mid-1960s and has since predicted every economic recession.

According to data from the New York Fed using the 10-year/3-month yield curve, an economic recession should occur about 12 months later. In fact, the Fed still expects a 56% chance of an economic recession by June 2025.

"It's been so long, you have to start questioning its usefulness," said Joseph LaVorgna, chief economist at SMBC Nikko Securities. "I don't understand how the curve could be wrong for so long. I tend to think it's broken, but I haven't completely given up."

Inversion is not an "isolated case"

What's more complex is that the inverted yield curve is not the only indicator showing that the United States may be heading into a recession.

Gross Domestic Product (GDP) measures the total value of all goods and services produced in all sectors of the U.S. economy. Since the third quarter of 2022, the average quarterly real growth rate has been about 2.7%, which is a fairly strong growth, well above the trend growth of about 2%.

Prior to this, U.S. GDP had negative growth for two consecutive quarters, meeting the definition of a technical recession, although few expected the National Bureau of Economic Research to officially declare a recession. Market expectations are for the U.S. GDP for the second quarter to grow by 2.1% when announced on Thursday However, economists have been paying attention to some negative trends.

The so-called Sam rule is a "foolproof" indicator, which believes that an economic recession will occur when the three-month average unemployment rate is 0.5 percentage points higher than its 12-month low. In addition, the money supply has been steadily declining since reaching its peak in April 2022, and the U.S. Chamber of Commerce's Leading Economic Index has long been negative, indicating significant resistance to growth.

"Many of these indicators are being questioned," said Quincy Krosby, Chief Global Strategist at LPL Financial. "At some point, we will fall into a recession."

Is this time different?

"We have some indicators that have not been effective," said experienced economist and strategist Jim Paulsen, who has worked at various companies including Wells Fargo. "We have experienced some situations similar to a recession."

Paulsen pointed out some unusual occurrences in recent years that may account for this difference. Firstly, he and others noted that the economy actually experienced a technical recession before the inversion. Secondly, he mentioned the Fed's unusual behavior in the current cycle.

Faced with the highest inflation rate in over 40 years, the Fed began gradually raising interest rates in March 2022, and then accelerated the pace in the middle of the year, contrary to its past practices. Historically, the Fed would raise rates early in the inflation cycle and then start cutting rates later.

"They waited until inflation peaked and then continued to tighten policy. So the Fed has been completely out of sync with inflation," Paulsen said.

However, the dynamic of interest rates has helped companies avoid the impact that an inverted yield curve typically brings.

One of the reasons an inverted yield curve can lead to a recession, and one of the reasons it signals a recession, is that it makes short-term funds more expensive. For example, this can be challenging for banks that borrow short-term funds and lend long-term funds. As the inverted yield curve affects their net interest margin, banks may choose to reduce lending, leading to reduced consumer spending and ultimately an economic recession.

But this time, companies have been able to lock in long-term rates at low rates before the Fed started raising rates, providing them with a buffer against higher short-term rates.

However, this trend increases the Fed's risk as a significant portion of this financing is about to mature.

If the current high rates persist, companies needing to roll over debt may face greater difficulties. This could create a "self-fulfilling" prophecy for the yield curve. The Fed has paused rate hikes for a year, with its benchmark rate at a 23-year high. Moody's economist Zandi said:

"So it's very likely that the curve has been deceiving us all along, but it may soon start telling the truth, and I'm very concerned about the inverted curve. This is another reason the Fed should cut rates, they are taking a risk."