A favorite indicator among economists for predicting recessions is the yield curve—the difference between long-term rates and short-term rates. As of this writing, the difference between 10-year Treasuries and 2-year notes is 0.30%, a decrease from just under 1% a year ago. When this relationship flattens and goes below zero, it’s believed that the economy is likely to enter a recession.
This time around, however, there are many technical issues to consider before jumping to any conclusions about the likelihood and timing of a recession.
Since 2008, the Federal Reserve has been paying interest on reserves, something the Fed has never done before. This helped the Fed target interest rates and put a floor under rates when the fed fund target was near zero. While many banks parked money at the Fed, it gave them options when liquidity was very tight.
Recently the Fed raised the fed funds rate but did not move the discount rate, which created an arbitrage. Those firms that could borrow at the discount window would loan to firms that didn’t have access to the discount window and lend to them at the higher fed funds rate. This activity will put more upward pressure on short-term rates due to excess demand from banks borrowing at the discount window but will have little impact on longer-dated rates. The result, in our view, will be further flattening of the yield curve.
More important, the Treasury has decided to fund the recent shortfall in the budget by selling 90-day paper. The tax cuts, while possibly stimulative, have created one of the largest increases in the deficit since 2008. The concern is that GDP might not grow faster than the deficit. While I think this is less likely as the economy continues grows—as evidenced in the current level of the proprietary Astor Economic Index® (AEI)—I feel confident that GDP will grow faster than the deficit.
That said, I am curious as to why the Treasury decided to fund this deficit with short-term paper while interest rates on the 10-year are below 3%, clearly an historically low level. Perhaps the thinking is this is a short-term need or that long-term rates will not rise as much as many people think. It’s interesting to note that demand for “risk-free” assets is still very strong globally. This too will increase the pace of yield curve flattening.
While these technical factors may sound like an excuse to ignore the yield curve signals, I believe it’s important to note that an inverted yield curve is not an instant red light on the economy. There are often substantial lags. There may be many who believe “this time is different”—which I’m inclined to agree with. What is different, though, is the lag between an inverted yield curve and a recession—not that this indicator is broken.
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The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.
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