Economist who pioneered closely-watched recession tool says it may be sending ‘the wrong signal’

For months, the bond market has issued multiple warnings that a US recession may be on the way, a view many in the financial markets are finally accepting.

One is the 10-year-minus-3-month Treasury yield spread, which has been below zero since late October, but has not been negative long enough to send a definitive statement about the pending economic downturn. Now, Campbell Harvey, a Duke University finance professor who pioneered the use of this spread as a predictive tool, says the measure may be sending “the wrong signal, which is interesting because I invented the indicator.”

The surprising conclusion from Harvey, whose 1986 dissertation at the University of Chicago linked the difference between long-term and short-term interest rates to future US economic growth, at a time when the broader financial market was concerned about a potential economic downturn in 2023.

On Tuesday, DJIA US stocks,
+0.28%

SPX,
+0.10%
It managed to recover from four consecutive sessions of declines as investors weighed recession fears and a sudden policy shift by the Bank of Japan. In the bond market, there were 41 different negative spreads as of Tuesday, according to Dow Jones market data — a sign of pessimism about the economic outlook.

The spread between the prices on a 3 month invoice TMUBMUSD03M,
4.308%
And the 10-year has been negative for nearly two months – a reversal of the 10-year trading at a much lower price than its 3-month counterpart – and ended Tuesday’s New York session at -66.3 basis points. Eight of the past eight recessions have preceded such reversals. The corresponding spread between 2-year returns BX: TMUBMUSD02Y and 10-year returns BX: TMUBMUSD10Y has consistently remained below zero for about six months, although it has sent at least one false signal in the past, according to Harvey.

In an interview with MarketWatch, Harvey, the Canadian-born economist, said one reason for his current view is that the 3-month/10-year spread as a model is “so well-known now that it has influenced behaviour,” causing both businesses and consumers to become more cautious. A form of “risk management” that “makes the possibility of a soft landing more likely”.

“We’re in a period of slow growth, which is consistent with the model, but as far as a recession is concerned, I’m skeptical about that. He said over the phone, though he didn’t rule out the possibility of a soft landing. “What I’m saying is pretty straightforward. This is a valuable indicator that I believe is accurate in predicting slowing economic growth. Regarding the hard landing, you need to look at the other information.”

Source: Tradeweb

Typically, Treasury spreads should widen and trend upward rather than downward, as investors factor in brighter growth prospects and seek additional compensation for holding a bond or bonds for a longer period. They’ve been shrinking below zero, or flipping, as the Federal Reserve continues to raise interest rates and investors factor in the potential impact of those moves down the road.

On October 26, the 3-month/10-year spread ended the US trading session below zero for the first time since March 2, 2020. At the time, Harvey said he would need to see the spread stay below zero through December to be confident a recession is on the way. This indicator has not yet been reached, with less than two weeks left in the year.

Here are the reasons the professor now cites why the spread may not be a reliable indicator of an approaching recession this time around, even though it clearly points in the direction of “slow” economic growth:

  • Unusual working condition. While unemployment is low before each recession, it is unusual for there to be such an excess demand for labor as there is now in the United States. This means that laid-off workers can quickly find work. ”

  • Layoffs due to technology. Layoffs from companies like Meta Platforms Inc. META,
    +2.28%And the
    The parent company of Facebook and Twitter is “highly skilled and has had a very short period of unemployment,” in contrast to the 2007-2008 global financial crisis and the brief COVID recession in 2020, which took away a broader pool of workers than other industries.

  • Powerful consumers and financial institutions. Consumers and the financial sector are stronger than they have ever been. This makes it less likely that falling home prices will cause contagion, Harvey said, or that any problems in the financial sector could spread quickly through the economy.

  • inflation returns. Harvey focuses on inflation-adjusted returns because they better reflect real economic expectations. “Once we adjust for returns from inflation, the yield curve does not invert – but it is flat (associated with lower growth but not necessarily a recession),” he said.

  • Alterations in behaviour. Because of the inverted yield curve, the company is less likely to “bet” on a major investment project plus consumers are careful and have plenty of savings, according to Harvey. “All of this leads to a self-fulfilling prophecy—declining growth. However, you can also view it as risk management. Even if growth slows, companies can succeed without mass layoffs.”

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