The flattening yield curve has sparked worries that a new recession is near, but the near-term outlook for growth still looks healthy, based on the latest set of nowcasts for third quarter GDP, as compiled by The Capital Spectator. The median estimate points to a solid 3.3% increase for Q3 output. Although that’s down from the 4.1% advance reported in in the “advance” Q2 report, the current projection suggests that the risk of economic contraction is low for the immediate future.
The Treasury yield curve, however, appears to be signaling a different risk profile. The widely followed spread between the 10-year Treasury yield less its 2-year counterpart ticked down to 18 basis points on Monday (August 27), based on daily data from Treasury.gov – an 11-year low. The slide suggests that recession risk is rising. If and when the spread goes negative, which appears imminent, a formal recession signal will arrive.
A research note published yesterday by the San Francisco Federal Reserve advises that “in light of the evidence on its predictive power for recessions, the recent evolution of the yield curve suggests that recession risk might be rising.” But with long rates still above short rates, “the flattening yield curve provides no sign of an impending recession.” All the more so when measuring recession risk via the bank’s preferred spread: the 10-year rate and the three-month Treasury rate, which is currently 73 basis points, or moderately higher compared with the 10-year/2-year spread’s 18 basis points.
If recession risk is rising, the warning isn’t showing up in the median Q3 GDP estimate via the numbers below. The outlier on the downside is the New York Fed’s current nowcast (August 24). The bank sees growth in Q3 easing to 1.96% (seasonally adjusted annual rate), which represents less than half the pace in Q2. Yet other models currently see output increasing by 3.0%-plus in Q3. Until the New York Fed’s estimate for substantially weaker growth is confirmed from other sources, it’s reasonable to treat this warning as a noisy outlier.
Even if the yield curve inverts at some point, the conventional interpretation of the signal is that a recession is lurking down the road – perhaps within a year. But a lot can happen in 12 months, including a change in monetary policy that attempts to ease recession risk.
Meanwhile, there’s an ongoing debate about whether the Fed’s extraordinary efforts at manipulating interest rates following the financial crisis in 2008 have reduced the power of the yield-curve signal for business-cycle analysis.
“The relation between yield curve inversions and recessions is likely to break down, as did the Phillips curve in the 1960s and the relation between stimulus and inflation in the 2010s,” writes Larry Siegel, director of research at the CFA Institute Research Foundation.
Perhaps, although the truth is that no one really knows if an inverted yield, whenever it arrives, will once again be a reliable warning that a new recession is near. Fortunately, there are options for business-cycle intelligence, starting with real-time analysis that reveals if a new NBER-defined downturn has started in the recent past – a far more practical and statistically robust methodology for analyzing the business cycle. By that standard, US macro momentum remains strong, as outlined in last week’s economic profile.
As valuable as forecasts via the yield curve can be, best practices for assessing recession risk start by objectively analyzing a broad set of indicators in real time — on a regular basis. Trying to look into the future with the yield curve and other indicators can be a useful supplement, but it’s no substitute for assessing what just happened. As Yogi Berra reportedly quipped, you can see a lot just by looking.