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US Recession Looms, Yield Curve Inversion or Not

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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.

Gap between 2-, 10-year Treasury yields foreshadows slowdown. Source: Bloomberg 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.

Now add in tariffs, which can raise prices inefficiently, thus giving an upward tilt to inflation that is not based on demand. In the case of steel and aluminum, the U.S. produces far less than it uses. The consulting firm Trade Partnership put out a report saying the Trump administration’s proposed tariffs would eliminate a net 179,000 jobs, overwhelming any gains enjoyed by the U.S. steel and aluminum manufacturers. And, we don’t even know the impact of any retaliatory tariffs by other countries or if certain countries decide to respond by purchasing less U.S. debt. Either way, this again points to upward pressure on yields rates for reasons unrelated to actual growth or demand-based inflation.

Foreign ownership of U.S. Treasuries. Source: Bloomberg Source: Bloomberg

Need more? Consider that real income gains remain tepid and consumption that has been fueled by a lower savings rate, which fell to a 10-year low of 2.7 percent in the fourth quarter. Presumably, borrowing at higher interest rates will prove at least somewhat problematic to consumers. Oh, and the Fed said last month that American households’ outstanding debt climbed to a record $13.1 trillion in the October-December period.

U.S. davings rate drops to lowest since 2007. Source: Bloomberg Source: Bloomberg

The change in the structure of U.S. deficits, the ownership of debt, and influences from the likes of tariffs and stimulus well into an economic recovery suggests the path to a yield curve inversion will be harder than before. Looking at recessions before the 1950s, only about half were preceded by an inverted curve.

This is all to say we may not need an inverted yield curve as the final arbiter of a recession. I could see it as a late 2019 event, just before the 2020 elections. The next recession could be relatively shallow, I’ll allow, but the resulting recovery, like this one, could prove frustratingly shallow as well.

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David Ader is chief macro strategist at Informa Financial Intelligence. He was the No. 1 ranked U.S. government bond strategist by Institutional Investor magazine for 10 years.