The Inverted Yield Curve and Recession Fears: A Self-Fulfilling Prophecy?

 

10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity
10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity

 There's a well-known theory that when the yield curve inverts, a recession usually follows within a year. This was observed in late 2022 when the yield curve inverted, but as of now, the anticipated recession has not materialized. Does this mean the theory is flawed? Not necessarily. While I’ve covered the theoretical underpinnings before, let’s focus on what's different this time compared to the past.

Changing Awareness and Market Sentiment

In the past, only experts understood the significance of an inverted yield curve, and they were the ones issuing recession warnings. Most people didn’t pay much attention to such indicators. However, today, thanks to platforms like YouTube and other accessible information sources, individual investors are far more informed and engaged. Now, when the yield curve inverts, it’s not just the experts who get worried—ordinary people start to anticipate a recession as well.

This shift in awareness means that recession concerns are no longer confined to financial professionals. With more people understanding the significance of these economic indicators, fear of an economic downturn spreads more quickly and widely. As the number of people worrying about a recession increases, conversations about the economy become more common, amplifying the fear of a slowdown.

Fear-Driven Behavior and Its Economic Impact

When many people start to worry about a recession, it influences their actions. Consumers may cut back on spending, while businesses may reduce hiring and delay investments. Layoffs could increase—not because the inverted yield curve directly causes it, but because enough people believe a recession is imminent. The widespread expectation of a recession can help bring about the very downturn everyone fears.

This differs from past economic cycles, where far fewer people paid attention to indicators like the inverted yield curve. Now, with recession concerns more prevalent, the narrative around an economic slowdown spreads faster and more effectively. As a result, governments and central banks are pressured to take stronger, more immediate actions to counter these fears.

Government Response: Proactive Measures to Counter Recession Fears

The U.S. government, for instance, responded to these growing fears by increasing fiscal spending starting in late 2022. This proactive approach included measures such as student loan forgiveness, aimed at injecting money into the economy and mitigating the effects of a potential recession. These fiscal interventions helped prevent an early downturn by providing financial relief to millions, effectively curbing recession risks before they could fully materialize.

Real-time Sahm Rule Recession Indicator
Real-time Sahm Rule Recession Indicator

The "Sham Law" and Heightened Concerns

Another factor contributing to recent recession fears is the rise of the so-called "Sham Law." According to this concept, when unemployment—previously at record lows—begins to rise even slightly, it could surge uncontrollably, leading directly to a recession. In early August, U.S. employment data showed a small uptick in unemployment, disappointing markets and reigniting fears of an economic slowdown.

These fears were further exacerbated by capital flight from the U.S., exemplified by the unwinding of yen carry trades on August 5. The rapid market response to these developments reflects how much faster the economy reacts today compared to the past. During the Silicon Valley Bank collapse earlier this year, for instance, the term “thumb runs” gained popularity, highlighting how quickly individual investors can act based on mobile trading. The economy moves at a faster pace, requiring swift responses from both the market and policymakers.

The Federal Reserve’s Response: Navigating New Realities

Federal Reserve Chair Jerome Powell and other officials have noted these changes in market behavior. Unemployment, for example, may not be rising because of mass layoffs but due to an increase in labor supply from immigration. However, many people are less concerned with the underlying causes and more focused on the fact that unemployment is rising. As more people believe in the "Sham Law" and fear that a recession is imminent, their actions can push the economy in that direction, regardless of the actual reasons behind unemployment increases.

Another key factor is the current balance in the labor market. With the ratio of job openings to job seekers now at about 1:1, any reduction in job openings could cause unemployment to rise more quickly. Even if the causes are different from past recessions, the narrative around a potential economic downturn is gaining traction, increasing the likelihood of a recession. This forces the Federal Reserve to stay vigilant and respond quickly to changing economic conditions.

The Fed’s Recent Rate Cut: Prioritizing Growth Over Inflation

In response to growing recession concerns, the Federal Reserve took the unusual step of cutting interest rates by 50 basis points in September. This marked a clear shift in the Fed’s focus—from controlling inflation to preventing a potential recession. Throughout the first half of 2023, inflation concerns dominated monetary policy, but by the second half of the year, the fear of slowing growth and recession took center stage.

The fact that the Fed chose to cut rates indicates that its concern about a potential recession outweighs its fear of inflation for now. Although inflation remains a risk, the Fed seems more focused on mitigating recession risks, particularly as the pace of economic change has accelerated in recent years.

Slowing the Pace of Rate Cuts: A Delicate Balance

As the fear of recession loses its grip on public consciousness, the narrative around an impending downturn starts to weaken. Some liken it to the story of the "boy who cried wolf." If fewer people are worried about a recession, they’re less likely to cut back on spending or investment, reducing the chance of an actual downturn. This gives the Federal Reserve room to slow the pace of rate cuts without causing major economic disruptions.

Currently, both hawks and doves within the Federal Reserve seem to agree on the need to bring interest rates down to a neutral level, likely around 3.25–3.5% by the end of next year. There is also a consensus that rate cuts should be implemented cautiously, without excessive speed, to maintain economic stability. The fact that the Fed, the markets, and analysts share a similar view on the future of interest rates is unusual and suggests a coordinated approach.

Adjusting Economic Policy: A Metaphor for the Fed’s Approach

Imagine driving a car on a highway. You can control your speed by either pressing the brakes or easing off the gas. On the highway, you don’t need to use the brakes as much; instead, you make small adjustments to the accelerator to manage your speed. This is how the Fed is currently approaching interest rate cuts—they’re carefully easing off the gas, rather than slamming on the brakes.

While the U.S. is managing this delicate balance, Japan faces a more complicated situation.

Japan’s Struggle with Growth and Inflation

Japan has been wrestling with rising inflation, but its central bank has been hesitant to raise interest rates due to concerns about stifling growth. Earlier this year, Japan’s government tried to take a gradual approach to rate hikes, but the yen’s rapid depreciation and concerns about inflation forced them to shift their focus. However, this led to the unwinding of yen carry trades, creating further instability.

As the yen weakened, Japan was forced to reconsider its policies yet again, highlighting the difficulties of managing inflation and growth simultaneously. The stop-and-start approach to economic policy reflects Japan’s challenge in finding a clear direction.

China: A More Complex Challenge

China’s economic challenges are even more severe. The country’s real estate bubble has created a situation where stimulus measures intended to boost growth are largely absorbed by the property market, leaving the rest of the economy starved of support. This dynamic makes it difficult for China to effectively manage its economy without exacerbating the real estate problem.

However, the fear of long-term stagnation, similar to Japan’s "lost decades," has prompted Chinese authorities to take more aggressive action. They’ve introduced a comprehensive policy package that includes rapid interest rate cuts and other measures aimed at stimulating the economy.

In summary, the U.S., Japan, and China are all facing unique economic challenges. The U.S. is carefully balancing recession fears with inflation concerns, Japan is grappling with a fragile recovery and rising prices, and China is navigating the complexities of a real estate-driven slowdown. Each country’s response highlights the growing complexity of managing economic policy in today’s fast-paced, interconnected world.

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