Why an indicator that has foretold almost every recession doesn't seem to be working anymore
The situation has many on Wall Street scratching their heads about why the inverted curve has been so wrong this time
Wall Street’s favorite recession signal started flashing red in 2022 and hasn’t stopped — and thus far has been wrong every step of the way.
The yield on the 10-year Treasury note has been lower than most of its shorter-dated counterparts since that time — a phenomenon known as an inverted yield curve which has preceded nearly every recession going back to the 1950s.
However, while conventional thinking holds that a downturn is supposed to occur within a year, or at most two years, of an inverted curve, not only did one not occur but there’s also nary a red number in sight for U.S. economic growth.
The situation has many on Wall Street scratching their heads about why the inverted curve — both a signal and, in some respects, a cause of recessions — has been so wrong this time, and whether it’s a continuing sign of economic danger.
“So far, yeah, it’s been a bald-faced liar,” Mark Zandi, chief economist at Moody’s Analytics, said half-jokingly. “It’s the first time it’s inverted and a recession didn’t follow. But having said that, I don’t think we can feel very comfortable with the continued inversion. It’s been wrong so far, but that doesn’t mean it’s going to be wrong forever.”
Depending on which duration point you think is most relevant, the curve has been inverted either since July 2022, as gauged against the 2-year yield, or October of the same year, as measured against the 3-month note. Some even prefer to use the federal funds rate, which banks charge each other for overnight lending. That would take the inversion to November 2022.
Whichever point you pick, a recession should have arrived by now. The inversion had been wrong only once, in the mid-1960s, and has foretold every retrenchment since.
According to the New York Federal Reserve, which uses the 10-year/3-month curve, a recession should happen about 12 months later. In fact, the central bank still assigns about a 56% probability of a recession by June 2025 as indicated by the current gap.
“It’s been such a long time, you have to start to wonder about its usefulness,” said Joseph LaVorgna, chief economist SMBC Nikko Securities. “I just don’t see how a curve can be this wrong for this long. I’m leaning toward it being broken, but I haven’t fully capitulated yet.”
The inversion is not alone
Making the situation even more complicated is that the yield curve isn’t the only indicator showing reason for caution about how long the post-Covid recovery can last.
Gross domestic product, a tally of all the goods and services produced across the sprawling U.S. economy, has averaged about 2.7% annualized real quarterly growth since the third quarter of 2022, a fairly robust pace well above what is considered trend gains of around 2%.
Prior to that, GDP was negative for two straight quarters, meeting a technical definition though few expect the National Bureau of Economic Research to declare an official recession.
The Commerce Department on Thursday is expected to report that GDP accelerated 2.1% in the second quarter of 2024.
