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Analytics, 03 June 2022

An inverted yield curve: is a recession imminent?

Because of the inversion of the widely observed yield curve (USA), an indicator that measures the difference in interest rates between short-term and long-term bonds, there has been a global fear among experts and investors on a looming recession. The US yield-curve inversion happened in March 2022, the first time since 2019 and while the indicator is not full-proof, investors are watching the situation closely.

Most global economies are also currently undergoing a stagflation, defined as a slowing economic growth combined with high inflation, forcing central banks to raise their benchmark interest rates in an aim to curb inflation Historically, a stagflation is extremely hard to control, as raising interest rates slows economic growth and increases the chances of a recession.

The Ukraine-Russia war crisis has also had its part to play, with global supply chains disrupted due to sanctions on Russia, a global supplier of Oil and other products. This has consequently raised the price of gas globally.

However, other indicators of a recession like the unemployment rate, which remains historically low in the US at 3.6%, a strong trend in job growth, and rising consumer spending indicate a recession is unlikely to happen.

The yield curve inversion

The yield curve has historically been used as the ‘holy grail’ indicator for economic performance. The yield curve shows the interest rates that buyers of government debt demand in order to lend their money over various periods of time — whether overnight, for one month, 10 years, or even 100 years. In all previous recessions, the yield curve has inverted 18-24 months prior; a factor that has led various players in the economics sector to believe a recession is imminent. There have been instances, however, more so recently, where there were inversions but a recession was not recorded, despite a slow economic growth in the months that followed. Some experts argue that the Fed policy tightening and increased interest rates have greatly affected the signaling power of the yield curve.

Inflation and central banks raised interest rates

Since World War II, the US central bank has had 14 instances where it embarked on controlling inflation by raising interest rates and policy tightening. Eleven of those instances were followed by a recession within 2 years. While only eight of those cycles can be attributed to the central bank’s activities, Goldman analysts believe that the current activities increase the odds of a recession to 15% in the next 12 months and 35% within the next 24 months.

Some economists believe the central bank waited too long to try to control inflation, consequently moving too quickly in recent months to stabilize prices. Sudden hiking of interest rates creates higher rates on consumer and business loans, forcing employers to cut back on spending and thereby slowing the economy. However, Central bank officials have come forward to vocally support their policy tightening, maintaining optimism that albeit difficult, they can control inflation without crushing the economy.

Jerome Powell, chair of the Board of Governors of the Federal Reserve System, cites the strong labor market, solid payroll growth, and strong business and household balance sheets as signs that the moves by the Fed to curb inflation don’t elevate the probability of a recession. “The probability of a recession in the next year is not particularly elevated. All signs are that this is a strong economy, and one that will be able to flourish in the face of less accommodative monetary policy,” Powell told reporters during the Fed’s March meeting.

Should investors be worried about a recession?

While some indicators show a recession is imminent, experts don’t expect it to happen in the next 12 months. The yield curve indicator, for example, only predicts a recession, if any, 18 months after the inversion. Other indicators including rising unemployment and declining consumer spending are usually experienced, but that is not the case today.

While slow economic growth is expected in the coming months and the war in Ukraine continues, disrupting supply chains, bundled up with the continued raised interest rates by central banks, a ‘soft landing’ is expected. Investors are advised not to make any drastic decisions yet, but stay vigilant nonetheless.

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