US Recession Looms, Yield Curve Inversion or Not

Other than in the most abstract way, there aren’t a lot of people talking about a coming U.S. recession. Sure, some say the Federal Reserve needs to raise interest rates now so it can lower them and have an impact when a recession hits, but that’s about the extent of the discussion. But I’m starting to see elements that could coalesce and show that a recession may not be too far away.

First — and perhaps foremost — there’s the Fed. Policy makers are boosting rates, have hinted at an inclination to be more aggressive, and are reducing the central bank’s balance sheet, which on the margin puts upward pressure on bond yields purely from a supply perspective. The yield curve is responding accordingly by flattening. I came across a San Francisco Fed Economic Letter outlining the value of the yield curve as an economic forecaster and how an inversion has preceded every recession in the last 60 years. Although the authors agree with the notion that the current flattening may not mean what it has in the past, they conclude that the yield curve remains a valid and formidable predictor.

Source: Bloomberg

Yes, the curve hasn’t inverted, but I suggest that there’s no absolute need for an inversion to precede a recession. My concern is the extra supply of bonds and other upward pressures on longer rates even as the Fed hikes, keeping long-term yields from falling below short-term yields. The ballooning budget deficit that will exceed $1 trillion next year and debt held by the public will rise from the current 74.3 percent of gross domestic product in coming years to more than 90 percent in 2026 — and that doesn’t include the impact of the recent tax reform. Debt-to-GDP was barely 40 percent at the end of the Reagan administration. The deficit has to be financed, and I suspect that will mean ever-higher rates, which will curb economic growth, to attract overseas buyers because we don’t have enough savings on the domestic front to do it on our own.

It’s not only about government debt. Corporate debt stands at a record 45.3 percent of GDP, and companies will face massive refinancing needs — at higher rates — as that debt matures over the next few years. All I hear is that the money saved from lower corporate taxes and the overseas cash — mostly held in Treasuries, by the way — that can now be brought back to the U.S. will be used for more share buybacks and M&A activity, not to reduce debt. Again, a source of upward pressure on rates.