May 20, 2022

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Explain the recession signal known as yield curve inversion

Explain the recession signal known as yield curve inversion

High inflation sky. High interest rates. Falling home purchases.

Analysts are working to digest a host of signals about the state of the US economy, which has emerged from the pandemic recession stronger than anyone could have imagined.

This week, those worrying trends collided with another key data point showing a contraction of US GDP in the first quarter of 2022.

However, many economists believe that an official recession – where the economy heads in the opposite direction for two consecutive quarters – is not imminent.

“This is noise, not a signal,” Ian Shepherdson, chief economist at the Pantheon Macroeconomics research group, wrote of the GDP data in a note to clients. “The economy does not fall into a recession.”

That sentiment was echoed by Bill Adams, chief economist at Comerica Bank, who noted in a tweet on Twitter that consumer spending, investment and job growth remain healthy.

Many Americans are still worried. Among the signs: Google searches for “stagnation” have spiked this month.

Google Trends data shows ‘stagnation’ searches up in AprilThe Google

“There are undoubtedly a lot of challenges for the US economy,” said James Knightley, chief international economist at ING financial services group. “You have a situation where families are feeling the pressure of rising fuel and food costs, and wages that don’t necessarily align.”

Recent consumer sentiment readings also indicate that many Americans aren’t sure where their financial future is headed. Complicating matters: The ultra-low interest rate environment that has dominated the US economy for years is coming to an end, as the Federal Reserve prepares to raise its key interest rate next week for the second time in nearly two months.

As a result, while most economists are certain that growth will begin to slow in the coming months, there is debate about how severe the decline will be, and what that means for average Americans.

“People are getting wary – we are just starting to raise interest rates,” Knightley said. “It’s annoying to people.”

Warning signs

On Wednesday, the US Bureau of Economic Analysis reported that US gross domestic product, among the broadest measures of growth observed by economists, contracted by 1.4 percent. Gross Domestic Product represents the market value of goods and services produced in a country during a specified period of time.

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However, many economists were unfazed by the negative trend of the data, saying that it was mostly an anomaly of technical factors in how GDP is calculated.

In particular, the data was heavily influenced by the rise in imported goods – a sign that demand is still really strong.

“Because there is such a huge backlog of ships waiting to unload in US ports, imports remained high in the first quarter,” Comerica’s Bill Adams said, meaning America was running a trade deficit. “So it showed up as a drop in GDP, which means buyers will buy more foreign and less US products.”

But there are other signs that all may not be well in the economy. At the end of March, a major part of the bond market related to the recession emerged. It is known as an inverted yield curve. This is what happens when holding short-term bonds becomes more risky than holding long-term bonds.

According to the Federal Reserve Bank of San Franciscoinverted yield curves precede every recession since 1955, although sometimes it takes two years for an economic downturn to arrive after the reversal has occurred.

Only once, in the 1960s, did the curve reverse and the recession did not follow soon after.

on March 29 Inverse yield curve It means that bond buyers have decided that the short-term risks to economic growth are increasing compared to the longer-term risks.

That doesn’t completely rule out a recession, ING’s Knightley said. But it is a flashing warning sign that we must take seriously.”

Experts like Knightley worry that if the warning sign is correct, average Americans may begin to experience higher unemployment and slower wage growth, even as inflation begins to slow.

A steep yield curve has been a feature of our economic environment in recent months.

Where will inflation go from here?

It is not clear when the inflation slowdown will occur, or how fast. Some economists believe inflation peaked in March, when the consumer price index reached a 40-year high.

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However, many economists believe that inflation is likely to continue for some time. In a note to clients released this week, Bank of America said, “Recession risks are low now but high in 2023 as inflation could force the Fed up until it hurts.”

The bank refers to the Federal Reserve’s plan to raise interest rates to control inflation. The Fed said it will raise the benchmark interest rate six more times this year, which means the cost of borrowing money — to buy homes and cars, get student loans and take on credit card debt — will become more expensive.

“Every recession is different, but Fed hikes and commodity shocks have played a role in most of the recessions over the past few decades,” the bank wrote. “We are currently facing a modest version of both: a commodity shock from the Russo-Ukrainian war and massive Fed tightening. Moreover, higher commodity prices are part of a larger increase in inflation.”

For now, the bank said, the main “imbalances” in the economy are high spending on goods, and what it called a “potentially overheated labor market.”

She said inflation is currently weighing on real consumer spending, which has risen just 2.4 percent year-on-year over the past three quarters. Despite this, GDP data shows that spending remains strong, with some exceptions. Mortgage applications have recently fallen to their lowest levels in the post-Covid era, in large part due to higher interest rates.

But inflation may persist if aggregate consumer demand remains too strong, thanks to an overheated labor market and the associated covid-19 virus. Bank of America said lockdowns in China are affecting supply chains again.

“[Economic] The bank said the risks are high and should certainly be viewed as above average. If inflation comes in stronger than expected or growth falls quickly, stagnation will become the base case. But we’re not there yet.”

How should families prepare for a possible recession?

Jan Hatzius, chief economist at Goldman Sachs, noted in an April 17 note to investors that household balance sheets are in good shape.

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Household net wealth/disposable income ratio [is] Currently at a record high,” Hatzius said, noting stock market rallies through most of 2021 and the record amount of money saved during the pandemic. [is] “Managing a fiscal surplus is healthy,” Hatzius said.

“This means that a slowdown in income growth due to reduced demand for labor caused by monetary policy is unlikely to force households to cut spending sharply” — which means that families will likely continue to have the ability to spend money on what they need and want because Their financial budgets are very good at the moment.

“This is likely to raise the odds of avoiding a recession,” he said.

So what can consumers do to prepare for a recession? Ironically, it is the fear of economic deflation that can often lead to deflation.

“Planning for a recession is the perfect cocktail at the end of the day with a recession,” said Gregory Daco, chief economist at EY-Parthenon, Ernst & Young LLP. “So oftentimes it becomes a self-fulfilling prophecy: Consumers start buying less, or fall back, and then companies start having more financial hardship, they start hiring less, then incomes go down. And that again leads to a vicious cycle.” “

Ultimately, he said, it will fall to the Fed to tackle the economic chaos. For now, he said, an economic recession is not imminent. But depending on what the Fed does – and how markets respond – a recession may be a possibility in the next couple of years.

Dako said that while recession is a risk, it is not a guarantee. “There is no guarantee that we will end up in a recession, because the Fed will be able to rethink, reset monetary policy. But it is a risk as we look to 2023.”

So, some old tips remain true for individuals and families looking to bolster their finances before a recession: Have an emergency savings account, use no more than 30 percent of your available credit, pay off high-interest debt and be mindful of spending on non-essential goods and services.