“A Recession Sign Is Flashing Red. Or Is It?” - James Mackintosh

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Let’s start with an example from two years ago: following market drops and fluctuation for over two years because of the COVID pandemic, changes in bond yields for US Treasury bonds showed an interesting phenomenon: shorter term, less risky bonds were paying out a higher yield than their long-term, more risky counterparts. This situation is called the inversion of the yield curve, a graph that shows a healthy bond market where higher risk (typically longer term) yields pay out a corresponding higher yield for the investor.

Obviously this situation turns the bond market upside-down; since there is no incentive to invest long-term, the government faces a situation where they are practically giving out free money. On top of this, businesses lack the incentive to give out bonds because either the business will lose money on them or the bond price will not offer as much value as the treasury bond.

In this situation, there is widespread fear of a recession because the investors in the market do not trust the performance of the market in the long term. As other investors and consumers become aware of this trend, the fear is that they too will lose faith in the market and begin to sell or short sell their assets.

Why does this example matter? Since this point in time, the US market has rebounded and the current yield curve suggests perfectly average market performance. There seems to be no correlation between today’s situation and that of two years ago.

However, the “normal” yield curve in the market could also signify future economic downturns because the long-term yields fall below what is expected within the context of new policy and current political events in the US.

In the context of the current market, there is widespread stagnancy in anticipation of the Federal Reserve Bank’s changes to the interest rate. Many believe the Fed will cut interest rates to balance the interest rates, which are nearing their current targets. There are two outviews for this scenario: 1) it suggests that there will be a softer landing for treasury rates as interest and market fluctuation stabilize, but 2) it may follow historical trends of recessions following significant interest rate cuts. The uncertainty concerning the future state of the market is also playing a part in current market activity.

The market’s reaction to a potential rate cut will be mixed to say the least because of the various pros and cons associated with it. Some benefits would be lower inflation and therefore cheaper financing, inviting more economic growth. However, the concept that the Fed would cut interest rates in the first place could be interpreted as a sign that the economy is weakening, which would spread and cause nationwide crashes as consumers aimed to turn their assets into liquidity at a fair price before it dropped.

The article highlights the complicated relationship between the yield curve and current/future economics and market behavior. It takes into account historical circumstances and assesses both the good and bad aspects of the Fed’s actions and their relation to a potential recession. The article highlights the importance of not analyzing the yield curve one-dimensionally, but instead looking at the data and extrapolating future outcomes and their dependence on current market conditions.

It is important to also take external events into accounts. Some things during this fiscal year that could be affecting uncertainty about the markets include trade tensions between the US and China, increases in defense spending, and also uncertainty about the 2024 US election and its influence on post-2024 policy.

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Sources

Mackintosh, James. “A Recession Signal Is Flashing Red. Or Is It?” The Wall Street Journal, Dow Jones & Company, 11 Sept. 2024, www.wsj.com/economy/central-banking/a-recession-signal-is-flashing-red-or-is-it-da02b509.