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Economists don’t all agree on this point, but it’s hard to find one who doesn’t believe in the old investor adage that “this time it’s different” is one of the most dangerous phrases in markets.
So why does mentioning the recent behavior of a particular market phenomenon and its famous recession-predicting power almost always elicit a “yes, but” response?
This indicator is known as the yield curve inversion, which is the line drawn between US Treasury yields of different maturities, most commonly between two-year and 10-year bonds. It is typically upward-sloping to reflect the higher risk of lending over longer terms. When it inverts, meaning it changes direction so that long-term yields are lower, it implies expectations of lower rates to boost growth.
For some, the mere fact that Washington is cheaper per year to borrow over 10 years than over two years is a sign that something is wrong: Investors are accepting lower yields to take on more risk over time. For others, the inverted curve is slowing the economy, because banks are less likely to lend over the long term when they earn less.
Before each of the six U.S. recessions since 1980, the curve has inverted. For the four recessions since 1990, the inversion returned to a normal shape just before the onset of the recession, often because short-term yields were falling in anticipation of interest rate cuts.
After more than two years of inversion, two-year bond yields slipped lower than 10-year bonds two weeks ago. However, this week The S&P 500 hits a new record high after the Federal Reserve began cutting rates to help keep the economy in what Chairman Jay Powell called a “good position.”
Could it really be different this time? Yield curve proponents don’t think so. They often start by pointing to human psychology. Wall Street sells investment dreams, and no one likes to be the first to utter the R-word.
“I’ve been fired twice for predicting recessions. The fact that I was right has nothing to do with it,” says economist Gary Shilling, who believes in the yield curve signal but cautions that its movements do not indicate the severity of a potential economic downturn.
It’s also worth considering that sizzling stock markets and bond yield warnings often coexist. In 2000, the inversion began more than a month before the Nasdaq peaked in March of that year and ended three months before the recession began in March 2001, according to the National Bureau of Economic Research, the arbiter of U.S. business cycles. In 2006, the S&P 500 still had about 20% of its recovery to go when the curve began to reverse direction in June. Stocks didn’t peak until October 2007, four months after yields normalized and two months before the recession began.
“Most economists started talking about a recession in September 2008, not understanding that it wasn’t the financial crisis that caused it, but the Fed and the crisis that made it worse,” says David Rosenberg of Rosenberg Research. Considered one of Wall Street’s pessimists, he backed the predictive power of the curve at the time and believes a recession is likely this time around, too.
It doesn’t help that there is little consensus on which yield curve to follow. While two-year and 10-year Treasuries are common, many economists prefer to start with three-month Treasuries. Powell himself has made a case for a review of a curve covering only 18 months in a 2022 speech.
Goldman Sachs’ investment strategy group, which advises its wealthiest clients, tracks four different curves, all inverted, and still doesn’t see a recession as a base case. “The key question is whether this inversion is because the Fed is likely to engineer a soft landing or is it simply because they’re behind the curve?” asks Goldman’s Brett Nelson.
There’s always something that makes this period different. In 2000, the tech boom was transforming the economy. In 2006, long-term bond purchases by the Chinese and Japanese kept long-term yields low. This time, the reasons include the severity of pandemic-induced inflation.
“History casts a huge shadow. Ironically, the problem is that people continue to think about the historical shadow of the inverted curve instead of paying attention to the short-run dynamics,” says Fred Carstensen, an economic historian at the University of Connecticut.
Even as economists debate, investors should put their money to work and hope they don’t get too badly hurt, whichever side is right. “The recession has been delayed, but no, we don’t think it’s going to be avoided,” says Bryan Whalen, chief investment officer at asset manager TCW. “If we’re wrong and have a soft landing, there’s not a lot of upside potential – credit spreads are tight. If we’re right, it’s a boon in our favor. The odds are good.”
