Financial Indicator Indicates Impending Recession

A very reliable financial indicator, the yield curve has recently inverted. However, Wall Street has always considered this indicator as a harbinger of an imminent recession. Are we therefore going to experience a catastrophic year in 2024 economically, which could take with it the stock markets and bitcoin (BTC)?

An inversion of the yield curve

Many predicted that the policies of money printing press of the early 2010s would cause a hyperinflation. That rate hikes of the mid-2010s would lead to a recession.

And that the covid would create a new Great Depression, and so on. None of these pessimistic predictions have come true. Since around 2012, the American economy has continued to strengthen.

In the world of finance and in the financial press, many people think that it is possible to predict a recession well in advanceusing what we call yield curve.

When there is a “yield curve inversion,” a recession is expected to occur 6 to 12 months later. Historically, this indicator has proven to be quite reliable.

The last four or five times we’ve had a yield curve inversion, there’s been a recession shortly after.

Yield curve: a reliable indicator

In fact, this trend is especially true if we go back to the 1950s. The only time this indicator gave rise to a “false positive” dates back to 1966. One false positive in nine is a rather satisfactory result.

The other main thing you should notice on the chart is that the yield curve has inverted very recently. In fact, the reversal occurred in November 2022, More than a year ago.

The Most Commonly Used Indicator of Impending Recession has been flashing red for some time now.

And in this election yearwhere the fate of the country may well depend on the economic mood of Americans, the question of whether we are on the verge of a recession is a very important one.

But it is also true that in the 14 months since the yield curve inverted, we have yet to see a recession – or even anything close to one.

The Wall Street Journal conducts a monthly survey of economists and, in early 2023, the probability of a recession within a year was greater than 60%. As of this month, that probability has fallen to less than 40%.

What is the yield curve?

When we talk about a “yield curve”, we are talking about the difference between long-term interest rates and short-term interest rates on government bonds. Another name for this difference is “term spread”.

Long-term rates are generally higher than short-term rates. For what ?

Due to the risk of rising interest rates.

Long-term bonds

When you buy a long-term bond – for example, a 10-year bond – your money is not technically tied up for 10 years. If you need money today – if you have a medical emergency or if you’re laid off – you can sell your bond in the bond market and get money immediately.

But how much money can you get? It depends. If interest rates have increased since you purchased the bond, the price of your bond will have fallen.

Indeed, when interest rates rise, the price of existing bonds falls (because investors can now get new bonds that pay a better interest rate, so that they place less value on old bonds).

In this case, if you need to sell your 10-year bond before maturity, you will suffer a loss. (You can also hold your 10-year bond until maturity and get all your money back… but then you will have to leave your money tied up for years, earning what is no longer an attractive interest rate).

Short-term bonds

Short-term bonds, on the other hand, do not present very little of this risk. Short-term bonds lose much less value when interest rates rise – they are short-term, which means that they do not pay interest for a very long time.

Their interest rate therefore has less importance for their total value. Short-term bonds are therefore less risky than long-term bonds.

A yield curve trending upward in normal times

In finance, if something has higher risk, it must also have a higher return, in order to justify the higher risk.

So, long-term bonds generally pay higher interest rates than short-term bonds, in order to justify their higher risk. This is why there is generally a positive rate differential.

Another way of saying it is that “the yield curve is generally oriented upward”. These are just two ways of saying that Long-term interest rates are generally higher than short-term rates.

But it’s not always the case.

Sometimes, short-term rates are actually higher than long-term rates ! In this case, we are talking inversion of the yield curve. This means that the spread between short-term and long-term rates is negative.

Factors that favor the inversion of the yield curve

Basically it could be anything that increases short-term rates relative to long-term rates. In principle, it can be many things. Here is a list of 3 things that can affect interest rates differentially:

Lexpectations regarding the real economy

When the economy begins to grow rapidly, rates tend to rise naturally, because the return on investment is simply higher everywhere in a good economy.

In the event of a recession, rates naturally tend to fall, for the same reason. If investors start to be pessimistic about the real economy in five years, they will expect short-term rates to fall in five years.

Long-term rates will therefore fall now, as they are influenced by the expected movement of short-term rates. But short-term rates will not fall as much, because the expected recession is still far away.

The Fed

The Federal Reserve can raise or lower interest rates through monetary policy, buying and selling bonds.

Typically, when the economy is doing well, the Fed raises interest rates to avoid or reduce inflation, and when the economy is doing poorly, the Fed lowers interest rates in order to stimulate the economy.

In the past, the Fed only tried to control short-term rates, but since the days of quantitative easing, it sometimes also controls long-term rates.

But basically, rate hikes generally raise short-term rates relative to long-term rates.

Expected inflation

Remember, when we talk about “interest rates,” we usually mean of nominal interest rates.

But what really interests investors are real interest rates. If investors expect higher inflation, they will charge a higher interest rate on the money they lend, in order to compensate for the future inflation they expect.

If they expect inflation to be high in the short term and lower in the long term, they will charge a higher short-term interest rate, but a lower long-term interest rate.

These factors are not independent either. Fed policy affects both the real economy and inflation. The real economy and inflation influence each other and also cause the Fed to change its policy.

In short

So let’s put all these factors together and simply explain why inversions in the yield curve herald recessions.

There is an economic boom. Short-term interest rates are rising due to a strong economy. The strong economy is overheating, which causes inflation.

Short-term rates are rising even more as people expect high inflation to continue for some time. Rising inflation prompts the Fed to raise short-term rates to slow inflation.

These three factors – a strong economy, high inflation and Fed rate hikes – are driving up short-term interest rates. But people expect the economic boom and inflation to fade in a few years, thanks to the Fed’s action.

They further know that once the recession hits, the Fed will cut short-term rates. Long-term rates therefore do not increase as much, or even fall. And there you have it, we now have an inversion of the yield curve.

Why has the yield curve inverted in 2022?

But there is a big difference between today and yesterday.

In the 70s and 80s, inflation only fell when there was a recession. But in 2023, inflation fell before any recession.

We managed to escape inflation before suffering the brutal economic devastation of the early 1980s.

It is possible that it is only a temporary respite. It is possible that high interest rates, exacerbated by the shift to remote work, will eventually massacre the commercial real estate market and cause a new financial crisis and a great recession.

That we did not achieve a soft landing, as announced Jerome Powellbut to a delayed reaction. We will see.

Is the situation different this time?

But it’s also possible that this time will be different.

It is possible that the Fed has finally found a way to convince America that it takes inflation seriously without harming the real economy. And it is possible that this lowering of inflation expectations, along with falling oil prices and supply chains, were sufficient to curb post-pandemic inflation without the need for Paul-style demand destruction Volker.

Face With the recent inversion of the yield curve, the shadow of a recession looms, but the outcome remains uncertain in the current economic context. Regardless, these are just speculations and rough theories. We will undoubtedly have the answer at the end of 2024.