This Recession Indicator Is Flashing Warning Signs As Fed, War And Oil Threaten Economic Recovery

Topline

The widely observed yield curve, which measures the difference in interest rates between short-term and long-term bonds, has inverted this week—signaling a looming recession—and though many experts are particularly concerned given the heightened risks from rampant inflation and Russia’s invasion of Ukraine, others say there’s time for stocks to rally before the seemingly inevitable economic shock.

The yield curve inverted on Friday—a near-perfect historical indicator of a looming recession—but … [+] that doesn’t necessarily mean investors need to run and hide.

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Key Facts

Following a strong jobs report Friday morning, yields on 2-year Treasurys jumped 17 basis points to 2.45%, while those on 10-year Treasurys climbed 8 basis points to 2.4%—marking the second yield-curve inversion this week after a brief lapse Tuesday morning; in another inversion, yields on the 10-year Treasury dipped below 2.45% on Friday afternoon.

With 30-year yields at 2.45%, the full curve has not yet inverted, but “the shorter-end of the curve is steepening and… recession risks are rising down the road,” Oanda senior market analyst economy in the long run.

After the initial inversion on Tuesday, Morgan Stanley’s Michael Wilson sent a note to clients warning the investment bank expects the yield curve will fully invert this quarter and could signal slower economic growth, particularly as stocks reckon with additional volatility sparked by inflation and the war in Ukraine.

The Fed appears to be “very committed to doing whatever it takes to quash inflation,” but it “will be a challenge to orchestrate a soft landing,” Wilson notes, reiterating that risks of exogenous shocks to the economy are “elevated” given the Fed’s intent and ongoing geopolitical stress.

Though a Federal Reserve study in 2018 found every recession in the past 60 years has been preceded by a yield curve inversion, market analyst Tom Essaye of the Sevens Report says such an inversion doesn’t mean a recession is imminent, pointing out stocks tend to rally for about a year after an inversion between 2- and 10-year yields.

“Instead, it’s a signal that the bull market’s time is now limited,” Essaye says, predicting it’s possible the stock market’s performance could be strong for several more months.

Surprising Fact

This week’s yield-curve inversion marks the first since August 2019, less than six months before the Covid-induced recession.

Crucial Quote

“An inverted yield curve is something that raises a red flag, but doesn’t necessarily mean to run and hide—some of the best returns are after the yield curve inverts,” Chief Market Strategist Brett Ewing of First Franklin Financial Services said Friday. “We believe markets will steady and then rally heading into midterms and the fourth quarter.”

Chief Critic

“The Fed’s application of its framework has left it behind the curve in controlling inflation,” Bill Dudley, a former president of the Federal Reserve Bank of New York said in a Bloomberg opinion piece on Tuesday, slamming officials for being “slow to recognize” inflation risks and tighten policy. “This, in turn, has made a hard landing virtually inevitable.”

Key Background

Rocked by Fed tightening and Russia’s invasion of Ukraine, the stock market closed out its worst quarter since the market crash in early 2020 on Thursday, with the S&P falling 5% and the tech-heavy Nasdaq tumbling 9%. In a note to clients last month, Bank of America’s Ethan Harris said inflation risks are low now, but will be higher next year. The analyst is particularly worried that stronger-than-anticipated Fed tightening, combined with an oil price shock or other unforeseen event, would pose a “serious risk” of a recession. On Monday, the bank said it expects faster rate hikes in light of sustained inflation and lowered its forecast for gross domestic product growth next year to 1.7% from 1.8%, compared to 5.7% last year.