There’s been panic this month over tariffs, currency, and the ‘inverted yield curve.’ Here’s what it really means.
Christopher WHALEN
Is the U.S. economy headed for another recession? The short answer is no.
After a decade of aggressive market manipulation by the Federal Reserve’s Federal Open Market Committee, most of the indicators we use to assess economic growth and job creation have been distorted beyond recognition. The good news is that the economy has recovered from the depression of 2008 despite the actions taken by the Fed, Congress, and Washington agencies. The bad news is that it may not survive the after-effects of some of these actions.
First and foremost, investors point to the fact that the Treasury yield curve is inverted—short-term interest rates are higher than longer-term bond yields—as evidence of an approaching recession. The investment firm Sandler O’Neill sets the stage:
Over the past week, fresh salvos in the U.S.-China trade war have renewed concerns about slowing global growth and triggered a flight to safe haven assets. The S&P 500 has fallen 4.4% over the past week while the 10-year U.S. Treasury has rallied to yield 1.63%, its lowest level in nearly three years. The 3-month/10-year Treasury yield spread, a closely-watched recession indicator, has become even more inverted, which, in turn, has rekindled speculation about an imminent slowdown.
So is the yield curve being inverted a sign that America is sliding into recession? No. In fact, the U.S. economy is actually the strongest part of the global economy. Europe and Asia are far weaker, even leaving aside the question of trade tensions. That’s why nearly $14 trillion in debt around the world is trading at negative rates of return: investors in Japan, India, and Europe are desperate to buy safe long-term assets such as Treasury securities. The increased global demand for Treasury debt, combined with the large stock of Treasury and agency mortgage-backed securities siphoned off the private market by the Fed during “quantitative easing,” may also be forcing the yield curve negative.
A second, related reason why the yield curve is negative is the dollar. Global investors have been hesitant to purchase Treasury securities, private bonds, and other assets in the U.S. out of fear that a strong dollar would wipe out their returns. Now with the dollar starting to weaken, large investors such as central banks and giant institutions such as Japan’s Norinchukin are back into the market, buying U.S. securities and driving down yields on Treasury bonds, and then selling the dollar foreign exchange risk to lock in safe returns.
So the two chief reasons for an inverted yield curve—low or negative interest rates and a huge demand for safe assets—have nothing to do with the direction of the U.S. economy. Indeed, the economy continues to grow strongly, albeit at slower rates than from 2016 to 2018. Brian Wesbury, chief economist at First Trust Advisors, argues that we’re doing just fine:
The rate of growth in the service sector continued to decelerate in July, with the headline index falling to the lowest level in nearly three years. However, it still showed growth and we anticipate a re-acceleration in the service side of the economy in the second half of the year. It’s important to recognize that thirteen of eighteen service sub-sectors reported growth in July, while only five reported contraction. And, if survey respondent comments are any indication, direct impacts from the China tariff dispute remain minor, with only the construction and management/support services sectors claiming increased costs.
The third reason for the inverted yield curve has nothing to do with the performance of the economy and everything to do with the dismal job that the FOMC has done managing monetary policy. Since 2008, the Fed has managed to inflate asset prices for stocks, bonds, and real estate, but has created serious problems along the way.
The FOMC’s attempt to artificially raise short-term interest rates when there was no compelling reason to do so gave us the inverted yield curve. Now, under Jerome Powell, the FOMC must figure out a way to back out of this mistake without completely destroying what remains of the Fed’s credibility. In fact, the FOMC is probably the single biggest threat to the U.S. economy.
For literally years now, the FOMC has stated repeatedly that getting inflation up to a 2 percent level is the target of U.S. monetary policy, including quantitative easing and low rates. Yet none of the Ph.D. economists that populate the committee have taken notice of the fact that the apparent link between interest rates and inflation expectations has been broken for nearly half a century.
After the FOMC failed to reach its inflation target, the committee decided that it needed to raise short-term interest rates in order to have “dry powder” to use in the event of a recession. If you follow the tortured logic of the Fed, the central bank wanted to raise short-term interest rates so as to be able to lower them in the event of a recession. The result of this bizarre thinking has been the extreme market volatility seen since the end of June.
The good news is that the U.S. economy is actually doing just fine and, if left to its own devices, will continue to outperform the rest of the world despite the threat of trade wars and other maladies. The one note of caution, however, is that the FOMC is truly lost when it comes to forming monetary policy and the narrative the markets desperately need in order to make decisions about investments and risk. Were it possible to address the members of the FOMC, the message would be: “stand down, do nothing.” The economy will thank
The good news is that the U.S. economy is actually doing just fine and, if left to its own devices, will continue to outperform the rest of the world despite the threat of trade wars and other maladies. The one note of caution, however, is that the FOMC is truly lost when it comes to forming monetary policy and the narrative the markets desperately need in order to make decisions about investments and risk. Were it possible to address the members of the FOMC, the message would be: “stand down, do nothing.” The economy will thank you.
