Is the US yield curve hinting at a recession?

7 Jul 2022 , 10:12 AM

An inversion of the yield curve was last seen ahead of the COVID pandemic which devastated the world economy in 2020. What is special about 2022 is that the US yield curve flashed a recession signal in April 2022 and has now followed it up with another yield curve inversion in July 2022. We will come back to the connection between an inverted yield curve and recession in greater detail later, but to begin with let us restrict ourselves to the real GDP growth projections.

Data Source: GDPNow by Atlanta Fed

The graphic above depicts the quarterly real GDP growth over the last 3 years presented on an annualized basis. Normally, a recession is defined as two successive quarters of negative growth. For the first quarter ended March 2022, the US economy contracted by -1.6%. The final data for the June 2022 second quarter is yet to be announced so we have used the most reliable projection of US GDP growth, which is the GDPNow that is tracked real time by the Atlanta Fed.

What stands out in the above chart is not just that the real GDP in the US is projected to contract at -2.1% in the June 2022 quarter. Just last month, the GDPNow estimate had pegged the second quarter real GDP estimate at -1% and in just a few days, the estimates have deteriorated by a full 110 basis points. Unlike many of the other measures, the GDPNow is a pure mathematical measure and does not have any economist discretion. That means; in the last one month, there has been a palpable and identifiable worsening of the high frequency macro growth data.

Why recession in the US now?

The recession warnings are nothing new. The first warnings came about 2 months back when former treasury secretary, Larry Summers cautioned that too much hawkishness by the Fed could eventually translate into recession. That was eventually borne out by the first quarter data and now even the Atlanta Fed projections for the second quarter ended June 2022 are hinting at a full-fledged recession with 2 successive quarters of negative real GDP growth. However, Fed continues to be unrelenting on inflation control, notwithstanding unfavourable growth outcomes.

In its latest policy statement in June 2022 and subsequent pronouncements, Jerome Powell made it crystal clear that the US Fed would not compromise on inflation. Consumer inflation has been consistently above 8% in the US with pressure on food, fuel and core inflation. According to the US Fed, the only option in front of the US Federal Reserve was to pay a price in the form of GDP slowdown to arrest consumer inflation, which is seen as patently unjust. One outcome of aggressive rate hikes has been the inversion of the yield curve.

US Yield curve inverts for the second time in 3 months

It was only in April 2022 that the US yield curve had inverted after 2 years. That has been followed by another inversion in July 2022, as shown in the graph below.

Chart Source: Reuters

The above yield spread curve is the difference in yield between the 10-year yield and the 2-year yield. Logically, you must earn more on a 10-year bond than on a 2-year bond since the tenure risk is higher. However, when there are expectations of a recession, there is uncertainty about the future and nobody wants to invest for the long term. This makes the 2-year bonds more popular than the 10-year bonds leading to a spike in the 2-year bond yields. This results in negative spread creating a negative yield curve.

A positive spread (steepening curve) typically signals expectations for stronger economic activity, higher inflation and higher interest rates. A flattening or an inversion in the yield curve means investors expect near-term rate hikes but as a result are pessimistic about economic growth in the long run. That is the picture that the yield spread curve is depicting at this point of time. This is popularly called the (2/10) yield spread and is one of the most popular measures of yield curve inversion.

Is inverting yield curve a reliable indicator of recession?

During the current week, the yields on 2-year Treasuries spiked to 2.95%, while the 10-year yields stood at 2.94% created yield curve inversion. Earlier, the yield curve had inverted in April 2022 and before that it had inverted in late 2019 ahead of the COVID pandemic. Investors are getting sceptical about the Fed’s ability to control inflation without hurting growth. The market perception is that “Soft Landing” aspired by Jerome Powell is illusory.

Is this a really reliable measure. If you look at the last 6 decades, then the US curve inverted before each recession since 1955. Normally, a recession follows the yield curve inversion with a gap of 6 months to 24 months. If you look back since the year 1900, there have been 28 occasions when the (2/10) yield curve spread went into negative. On 22 out of these 28 occasions, there was a recession. In short, the yield curve inversion indicator does look real with a strong possibility of a recession as growth falters amidst stringent inflation control.

Takeaways for the Indian economy from US recession

There are several takeaways for the Indian economy from the US yield curve experience.

·         A US recession would mean compression in demand from the US, not a good feeling since India runs the largest merchandise trade surplus with the US.

·         Several knowledge based sectors like IT, pharma, healthcare, auto ancillaries and green technologies are heavily dependent on US outsourcing orders to keep the turnstiles ticking. A recession would surely dent US spending, including tech spending.

·         More importantly, it is a signal to the Indian central bank (RBI) that an ultra-hawkish approach to inflation control may not always be the answer. With a $9 trillion bond book, there is not much that the US central banks can really do to boost economic growth from here. India must keep its options open.

For now, the Fed is wedded to the idea of 2% inflation target. Preliminary data suggests that this obsession with inflation control has already translated into recession expectations. It remains to be seen if it also actually translates into recession. At least, economic history of the United States is not on the side of the Fed.