Is another US recession nearing?

• The yield curve has often been a precursor to a recession. Indeed, the last six American recessions started after the differential between the yield on the 10-year and the 2-year US government bonds turned negative.
• However, the yield curve is an imperfect recession signal. Parts of the curve may be inverted, but several other indicators, such as real interest rates, suggest that a recession is not imminent.
• That said, recession risk, while low, has been increasing in the last six months, largely driven by a US central bank touting more aggressive monetary policy.
• With inflation expectations clouded by geopolitical risk as well as central bank policy assumptions, there is a risk of a policy error from the US Federal Reserve as it hikes rates, sparking an economic downturn.
• Equities continue to appeal to bonds, despite any near-term noise. Given the rotation out of growth to value stocks seen in many developed markets this year, in the short-term investors may need to be even more selective, while longer-term ones may want to start looking at quality and growth stocks again.

The American economy saw a swift economic recovery last year following the sharp contraction in 2020 as the effects of the pandemic bit. The markets’ views of the world have shifted quickly to a mid-cycle scenario in the last three months. The next stage (a late cycle) is usually followed by recession. It seems too early to worry about one being on the horizon. However, the recent flattening of the US yield curve, as the difference between short-term and long-term bonds narrowed, may be seen by some as a warning sign of a downturn, and raises questions.

Recession indicator

Historically, the yield curve has been a reliable leading indicator of a recession. Indeed, the last six American recessions started after the differential between the yield on the 10-year and the 2-year (the so-called “2/10”) US government bonds turned negative.

With a 2/10 spread around 50 basis points (bp), down from 150bp a year ago, concerns are emerging in financial markets. While an inversion of the yield curve may be some time away, parts of the futures curve have started to invert.

An imperfect record

While the US yield curve’s track record as a leading indicator of a recession is second to none, it is still imperfect. The period between when an inverting curve and three consecutive months of contraction (or a recession) begins can vary substantially. In the late 90’s, it briefly inverted in 1998, before steepening again and collapsing in early 2000. The “dot-com” recession officially started in March 2001, some three years after the first inversion.

Most recently, there was an inversion in August 2019, followed by pandemic-induced “flash” recession between February and April 2020. This time, though, an exogenous, health-related shock, triggered the downturn rather than a typical end to the business cycle.

In addition to the yield curve’s previous short comings, the US curve is increasingly affected by factors that can weaken its power as a recession predictor. For instance, After the US Federal Reserve’s (Fed) asset-purchase programme of recent years means that the central bank now owns around a fifth of the country’s debt. In turn, yields across the curve have been distorted, and may not fully reflect the true shape of the American economy.

What is the risk of a downturn?

While the yield curve may suggest some cause for concern, other popular recession predictors, such as real interest rates, recession probability models, and composites of leading indicators, are not flashing red yet, and indeed suggest a low probability of one in the near term.

While the risk may be low, it has increased over the last six months. This is predominantly driven by a more hawkish sounding US central bank, as it looks to hike rates from ultra-accommodative levels. In doing so, there is a risk that the pace of hikes is too quick and the domestic economy starts to contract. Indeed, policy calls may also be complicated by geopolitical risks and their potential effect on economic growth.

Stagflation versus recession

There is a risk of “stagflation fears” reasserting themselves over the summer, such as seen in the second half of last year. This scenario could occur if inflation stays high, growth slows from elevated levels, and the Fed seems too prudent.

Such a scenario would be a decent backdrop for risk assets, especially if inflationary pressures moderate. That said, if the Fed is forced to aggressively combat inflation by tightening policy, then the curve would likely invert, as more hikes are priced in on the short-end of the curve. This would point to tougher times for investors.

Positioning

Overall, pro-risk portfolio positioning still appeals, with a preference for staying invested and continuing to prefer equities to bonds. Yet, there are challenges ahead. The increases seen in bond yields this year mean that rates may soon be worth locking into again. In equities, the opportunities from the value/cyclical tilt that has proved profitable this year seem to be gradually shrinking. Short-term investors may need to be even more selective, while longer-term ones may want to start looking at quality and growth stocks again.