Why common recession indicators no longer seem to work

Wall Street’s favorite recession signal started flashing red in 2022 and hasn’t stopped, being wrong every step of the way so far.

The yield is 10-Year Government Bond Since then, yields on short-term Treasury bills have been lower than yields on other Treasury securities, a phenomenon known as an inverted yield curve that has preceded nearly every economic downturn dating back to the 1950s.

However, conventional wisdom would have it that an economic recession would occur within a year of an inverted yield curve, and at the latest within two years. However, not only has the yield curve not inverted, but there are virtually no signs that the U.S. economy is growing in the red.

This has many on Wall Street scratching their heads about why the inverted yield curve (which is in some ways both a sign and a cause of a recession) was so wrong this time and whether it’s a sign of a continuing economic crisis.

“So far, it’s certainly been a complete liar,” Mark Zandi, chief economist at Moody’s Analytics, said, only half-joking. “It’s the first time we’ve had a reversal that didn’t lead to a recession. But having said that, I don’t think we can rest easy that the reversal will continue. Just because they’ve been wrong so far doesn’t mean they’ll be wrong forever.”

Depending on which duration point you think is most important, the curve has been inverted since July 2022 if measured by 2-year Treasury yields, and since October 2022 if measured by 3-month Treasury yields. Some prefer to use the federal funds rate, which banks charge each other for overnight loans, which would mean the inversion would continue until November 2022.

Whichever point you choose, a recession would have already set in. This inversion has only been wrong once, in the mid-1960s, and has predicted every austerity policy since.

According to the Federal Reserve Bank of New York, which uses a 10-year/3-month curve, a recession should occur in about 12 months. In fact, the central bank estimates that there is about a 56% chance of a recession occurring by June 2025, as the current gap indicates.

“It’s been so long that you have to question its usefulness,” said Joseph Lavorgna, chief economist at SMBC Nikko Securities Inc. “I don’t understand how the curve could stay wrong for so long. It’s likely to be breached, but it hasn’t completely caved in yet.”

To further complicate the situation, the yield curve is not the only indicator that shows reason to be cautious about how long the post-COVID recovery will last.

Gross domestic product, the sum of all goods and services produced across the vast U.S. economy, has averaged an annualized real quarterly growth rate of about 2.7% since the third quarter of 2022, a fairly robust pace well above what would be considered a trend increase of about 2%.

Prior to that, GDP had been negative for two consecutive quarters, meeting the technical definition, but few expected the National Bureau of Economic Research to officially declare a recession.

The Commerce Department is due to report Thursday that second-quarter 2024 GDP grew 2.1%.

But economists are noting some negative trends.

The so-called Sarm rule, a fail-safe measure that assumes a recession will occur if the three-month average of the unemployment rate is 0.5 percentage points higher than its 12-month low, is close to being set in. On top of that, the money supply has been declining steadily since peaking in April 2022, and the Conference Board’s index of leading economic indicators has been negative for a long time, suggesting major headwinds to growth.

“A lot of these measures are being called into question,” said Quincy Krosby, chief global strategist at LPL Financial Inc. “We’re going to have a recession at some point.”

But there are no signs of a recession.

“There were a number of indicators that went wrong,” said Jim Paulsen, a veteran economist and strategist who has worked for companies including Wells Fargo & Co. “There were a number of recession-like things.”

Paulsen, who now writes for the Substack blog “Paulsen Perspectives,” points to a few unusual events over the past few years that could be contributing to this disparity.

First, he and others point out that the economy actually went through a technical recession before the reversal, and he also points to the unusual behavior of the Federal Reserve in the current cycle.

Faced with a sudden rise in inflation to its highest levels in over 40 years, the Fed began gradually raising interest rates in March 2022, and then more aggressively by mid-year after inflation peaked in June 2022. This is a reversal of how the central bank has conducted policy in the past: Historically, the Fed has raised interest rates early in an inflation cycle and then begun to cut rates later.

“The Fed waited until inflation peaked before tightening dramatically, so their timing is completely off,” Paulsen said.

But interest rate movements are helping companies avoid what typically happens when yield curves invert.

One reason an inverted yield curve can contribute to or signal a recession is that it makes short-term funds more expensive. This is tough for banks, for example, who borrow short-term and lend long-term. When an inverted yield curve affects banks’ net interest margins, they may choose to lend less, which could cause a decline in consumer spending and lead to a recession.

But this time, companies were able to lock in lower long-term interest rates before central banks started raising rates, providing a buffer against rising short-term rates.

But these trends pose increased risks to the Fed as much of its money comes due for repayment.

Companies that need to refinance debt could face a tougher situation if current high interest rates persist. This could become something of a self-fulfilling prophecy for the yield curve: The Fed has kept rates on hold for a year, and its benchmark interest rate is at a 23-year high.

“So it’s entirely possible that the yield curve has been lying to us up until now, but it may start telling the truth soon,” Moody’s economist Zandi said. “We’re really worried about the yield curve being inverted, and this is another reason for the Fed to cut rates. They’re taking an opportunity here.”