Jerome in Wonderland – Recession on Horizon?

September 9, 2019
Jerome in Wonderland – Recession on Horizon, Market Commentary

“If I had a world of my own, everything would be nonsense. Nothing would be what it is, because everything would be what it isn’t. And contrary wise, what is, it wouldn’t be. And what it wouldn’t be, it would. You see?” – Lewis Carroll, “Alice’s Adventures in Wonderland & Through the Looking-Glass”

The title of my commentary is “Jerome in Wonderland,” because short-term interest rates are higher than long-term rates and certain segments of the yield curve have become inverted, which, of course, is not the normal way of things. Yield curve structure is ignoring the time honored structure where, the longer an investor is willing to tie up their capital, the higher the expected, and earned, return. In other words, what is up is down, and what is down is up.

This places Jerome Powell, the Chairman of the Federal Reserve, in an odd position. He and his group have the capability of eliminating the negative yield curve structure, if they act quickly and boldly. Will they do so? It depends on many variables but historically by the time the Fed is fearing an upcoming recession, such actions have tended to be too little, too late.

Yield Curve Structure and Recessions

You can’t turn on the television without someone bringing up the inverted yield curve or the spread between short- and long-term rates. Normally, short-term rates are lower than long-term rates. The rationale behind this relationship is irrefutable.

When the yield curve has inverted in the past, economic recessions eventually occur. While the same can’t be said about Fed rate changes leading to economic events, yield curve inversions have preceded all recessions in the last seven business cycles.

Jerome in Wonderland Table 1

Assuming this cycle is similar to historical norms, this data suggests a recession may start sometime in the last half of 2020 or beginning of 2021. The data does not support investors’ fears that, because we are experiencing yield curve inversion, a recession is just around the corner.

Why A Recession? 

Inverted yield curves don’t cause recessions. Inverted yield curves cause credit contractions. Credit contractions, given enough time and intensity, cause recessions. Recessions occur because of either a shortage or excess of some kind in the economy. A credit contraction is a shortage of capital availability.  It is the banking system starving credit-worthy borrowers’ access to capital.

Why does this happen? Banks, and shadow-banking entities (non-bank lenders) are in the business of making money. They tend to borrow short-term and lend long-term. When short-term interest rates are higher than long-term rates, lenders lose money because revenues received don’t match well with costs of capital. The result is that lending volumes start to slow. It is this dynamic at work that creates credit contractions, which, in turn creates business growth contractions.

I mentioned both banks and shadow banks in my comments above, because the funding structure of both of these credit creators tends to be different. Commercial banks have access to the Federal Reserve system. As such, their funding structure tends to be shorter term in nature than other lenders.  So, the relevant yield curve inversion comparison for commercial banks may be the 30-day Treasury bill versus the five-year treasury note. Currently that spread is -0.63 percent,1 a significant negative relationship.

The shadow-banking system, which has gained traction as a percentage of overall credit creation this business cycle, tends to be funded with longer-term borrowings. So, the relevant yield curve inversion comparison for this segment of the credit creation world may be the two-year Treasury compared to the 10-year Treasury yields. Currently, that spread is +0.04 percent.2 Last week, this relationship turned negative for a very short period. We will see how this all unfolds as we move forward. Bottom line, the fundamental economic reaction to yield curve inversion should start to show up over the next six months or so, unless the Fed takes action, aggressively and quickly.

With all of that being said, some would say “this time it’s different.” All business cycles and market environments are different, to one degree or another, from previous cycles. For example, the time variance of yield curve inversion-to-recession has, over the last number of cycles, been a whopping 26 months. To say that this cycle is going to act the same as previous environments, on average, could be wrong.

While lead times between yield curve inversions and economic recessions have been different, it is an absolute that recessions have always been preceded by yield curve inversions.

Weight of the Evidence Still Suggests Economic Expansion Over The Next 12 Months

The yield curve is one of four factors that historically has led us to call for the start of previous recessions. The other three indicators are:

  1. Six-month rate of change of the Leading Indicator Index (LEI). Over the last 10 business cycles, this indicator was -3 percent before nine of the 10 recessions.3 In other words, this indicator has had a 90 percent probability of correctly calling the start of a recession. At times, the lead time has been very minimal. What is this indicator telling us? Over the last six months, the LEI was flat, at a 0 percent growth rate.4 The trend of this indicator is negative, but it is saying if a recession is in the future, it is some time off.  
  2. Credit spreads. This is a measure of junk bond yields to U.S. Treasury yields. When bond market participants start to worry about rising credit default rates, this interest rate spread tends to widen. Currently the yield spread is 4.09 percent, up from a low of 3.58 percent in April.3 While not yet at an alarming level, the trend suggests bond market participants are starting to worry about rising credit problems.
  3. Purchasing Managers’ Index (PMI). Business people submit this index monthly, indicating whether business activity is expanding or contracting. A read of “50” is neutral. The ISM Manufacturing Index is at 51.2, down from 56.6 so far this year. The Markit Services PMI Index, which measures business activity from service-based companies, is at 53, down three points so far this year.3 While both indicators still suggest an expanding business environment, the declining trend is worth monitoring.

The other three indicators that we monitor suggest a positive economic environment at present, but we think that overall trends are deteriorating.

Recession – Why Will It Happen?

Although no one can predict what will happen to bring on the next recession, I firmly believe we will see one – it is part of the historical structure of economic cycles in a market-based economic system. 

Regarding the catalyst that could trigger the next downturn, recessions have been created by credit strains, and I don’t believe this time around is going to be any different. Credit strains are minimized by many things, but one factor is the ability of the world’s banks and investors to move investment capital from one part of the world to another.

With this in mind, I suggest building global nationalistic tendencies has the highest current probability of driving an economic contraction. As mentioned above, U.S. tariffs, U.K. Brexit, China’s aggressive business practices and European political unrest demonstrate that the world is moving toward a nationalistic focus rather than taking a globalization approach.

In general, the world has benefited greatly by the globalization focus during the last 40 years. For example, since 1990, the global deep poverty level fell from 36 percent to 11 percent of global population. In East Asia, the deep poverty level is down to 3 percent of that vast continent’s population.5 As nationalistic biases continue to gain ground, the ability of people to move investment capital from one place to another may start to be hampered. In other words, the benefit of global wealth spreading may slow specifically due to nationalistic tendencies. Economic inefficiencies tend to rise as decisions are made, which cater to one political agenda or another.

With the apparent benefits of globalization, why have nationalistic biases taken hold? I, along with highly skilled economists, place much of the blame on the developments that have driven national income allocation away from labor and toward capital. Corporate profits have soared from an average of 5 percent of national income to more than 10 percent6, reflecting the fact that labor’s share of the national income pie has shrunk. This shift in national income has morphed into the highly publicized issue of income disparity. 

For example, if we study the average pay of S&P 500 company CEOs and compare that compensation to the pay of the average worker of those companies, we find that CEOs make 360x the pay of their average worker. In 1980, that ratio was 42x. Additionally, a mere 8 percent of private sector workers today are unionized, while 42 percent of private sector workers were unionized in the late 1970s. Average workers believe they have been left behind during the last several decades, and frankly, they have a point.6

Politicians are taking advantage of the growing dissatisfaction with the world’s capitalistic system. They offer remedies such as trade management and socialist-biased solutions, but none will effectively address the problems at hand. I suggest a number of the solutions being offered will simply transfer economic power from the private sector to the government. Inefficiencies may escalate under most of these remedies, not decline, and workers will likely still be left in the lurch. Business uncertainties may indeed grow.

In the meantime, I expect further loose monetary policies will be adopted by many central bankers attempting to kick start global economic growth. We will probably see some kind of band-aid to the trade negotiations with China, but the crux of the global problem with that country may not be solved in the next year.

What is my bottom line? I believe the risk of a recession starting sometime in the next 18 months has increased. The ride going forward may be bumpy, but during economic contractions, risk-based asset valuations tend to become attractive. Recessions open up the markets with opportunities. The yield curve inversion is just a symptom of these problems, not the disease itself.  

1U.S. Department of the Treasury, Aug. 17, 2019.

2U.S. Department of the Treasury, Aug. 20, 2019.

3Ned Davis Research Group, April 30, 2019 and Aug. 30, 2019.

4The Conference Board, Aug. 2019.

5The World Bank,

6Strategic Economic Decisions,

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