Where’s the Recession? The Inverted Yield Curve Is Looking Like a Mistake.

The yield curve refers to the chart that plots U.S. Treasuries by maturity. Investors normally demand higher yields for longer, riskier maturities, so the curve is said to be inverted when short-term rates are higher than long-term ones. When the curve is inverted, investors are pricing in a recession, as they have been for the past two years. Most of the time, investors will get that forecast right. But not every time. And it should be clear by now that the inverted curve can’t cause a recession or we would surely have had one already.

The inverted yield curve wasn’t the only reflection of the expected recession. The rise in interest rates orchestrated by the Fed in 2022 contributed to the 20% decline in stocks and the massacre in the bond market, because investors believed that a recession was coming. After the recession failed to show up, the stock market rallied.

But why hasn’t the economy gone into recession? The Fed has raised rates substantially, and investors are assuming that monetary policy is tight. But can it really be tight when firms can finance themselves in the bond market at lower rates than they must pay to draw on their credit lines?

It has been argued that sluggish bank-loan demand is evidence of a weakening economy. Rather, it seems more appropriate to conclude that many firms, especially larger ones, don’t need to tap bank lines when they can lock up long-term financing at lower rates in the bond market. Furthermore, firms have an incentive to borrow in the bond market to pay off their credit lines and reduce their interest expense. So, the effectiveness of hikes in short-term rates has been undermined by the failure of long rates to move up enough to constrain growth.

Or to put it slightly differently, monetary policy is really not that tight when long-term rates provide a cheap out. The bond market has been a get-out-of-jail-free card.

Long-term rates have risen even while the curve has remained inverted. It’s fair to think that raises the hurdle for investment decisions across the board. But the cost of capital isn’t the only variable that matters for spending decisions. For example, mortgage costs are significantly higher, yet housing construction is holding up after last year’s weakness. Why? I think that reflects the magnitude of the shortfall of the existing housing stock.

After overbuilding in 2005 to 2007, the housing glut caused a massive credit crisis. That excess supply of housing has since been more than reversed by years of underbuilding, so there’s now a housing shortfall of at least 1.5 million units and quite possibly much more. It is notable that home construction has stabilized in 2023, despite the continued rise in mortgage rates. Builders can still promote sales by buying down rates, while buyers opt for smaller units or fewer amenities. Rates will probably need to rise more to really curtail new construction.

Many analysts keep expecting households to significantly reduce spending, especially as they run out of “excess savings” from the government’s pandemic support programs. Aside from the enormous difficulty in estimating excess savings, current income is by far the single most important driver of household spending. (Capital gains are No. 2.) And as job growth remains robust, wage rates are rising, and striking workers press for even larger wage increases, there is little prospect for a sharp decline in consumer outlays, as yet.

Income growth could hit a wall if companies run out of unemployed people to hire. But labor-pool inflows have been surprisingly strong, reinforcing income growth, so that wall may be further out in the future. Consumers are also somewhat insulated from the adverse effects of higher rates because they’ve overwhelmingly locked in low mortgage rates. And for good measure, debt levels are also quite low relative to income. Households are actually in very good financial shape.

Other activities reinforce the floor under the economy. Supply-chain dependency is encouraging firms to bring manufacturing onshore or near-shore, and government subsidies strongly incentivize such investment. Even so, higher rates surely are a headwind. But it is difficult to anticipate a large decline in capital investment with the government providing so much support in pursuit of its green initiatives.

Putting all of these considerations together, monetary policy isn’t biting as much as might be expected, and it certainly isn’t as tight as many believe. The recent rise in long-term rates may pose some additional restraint on economic growth, potentially obviating the need for more rate hikes to create some slack. But that’s hardly assured. The bottom line is that rates just might need to rise more than recognized, given the circumstances. At the very least, higher for longer appears to be the minimum expectation for the market.

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