(Bloomberg Opinion) -- There are no sure things in markets except maybe the bond yield curve's seemingly remarkable ability to predict recessions.
In short, yields on longer-term bonds are usually higher than those on shorter-term ones to compensate investors for the greater risk of bad things happening like faster inflation and default. But in the rare case when longer-term yields fall below shorter-term ones, the so-called yield curve is said to have inverted. This is an ominous sign because every recession since the 1950s has been preceded by an inverted yield curve.
When people talk about the yield curve, they are typically referring to the widely watched difference between two- and 10-year U.S. Treasury note yields. The gap is causing a lot of hand-wringing after it collapsed to a razor-thin 21 basis points from 158 basis points this time last year. Indeed, the economic outlook is a bit gloomy, with soaring energy prices, record-high food costs, a campaign by the Federal Reserve to raise interest rates to tame surging inflation and the rising threat of a military confrontation between Russia and NATO.
But a recession? Even the bond market thinks not. Sure, the two- to 10-year part of the curve is becoming dangerously flat, but orthodox curve watchers focus on the difference between the yields on three-month Treasury bills and 10-year notes. Here, the gap this week touched a healthy 180 basis points, the widest since early 2017. Studies over the years, including a groundbreaking one by the Federal Reserve Bank of San Francisco in 2018, explain why this part of the curve “is the most useful term spread for forecasting recessions.”
The simple fact is that consumers, whose spending makes up two-thirds of the economy, are perhaps in their best shape ever financially. Let's start with excess savings. Thanks to extremely generous social programs instituted by the U.S. government to support the economy through the Covid-19 pandemic, consumers have built up a staggeringly high cash cushion. Checkable deposits for households and nonprofit organizations rose to $4.06 trillion in December from $1.16 trillion at the end of 2019, according to the Fed. Looked at another way, the previous high for this metric before the pandemic was $1.41 trillion.
But what about the Commerce Report on Wednesday that showed retail sales growth slowed significantly in February to just 0.3% from 4.9% in January? Doesn't that show consumers are starting to buckle under the weight of the highest inflation rates since the early 1980s? Maybe not. Even though the number was below the median estimate for a gain of 0.4%, the January figure was revised significantly higher from the originally reported rise of 3.8%. Without that revision, February's increase would have been more like 1.4%, easily topping estimates. As Bloomberg Economics put it, “Retail spending was stronger than expected in February after incorporating upward revisions to January's blockbuster gain.”
Of course, nobody likes to pay more at the gas pump. And with the price of a gallon of regular gasoline as tracked by the American Automobile Association jumping to an average of $4.29 from around $2.39 at the start of last year, there's a lot of griping among consumers. The fact is, though, that spending on gasoline and energy as a percentage of disposable income has dropped by about half since the late 1970s and early 1980s. This is due to any number of factors but can best be summed up by saying that the economy has become much more fuel efficient.
What also makes this moment so much different from the recent past is overall wealth. U.S. household wealth surged $40.3 trillion since the start of the pandemic to a record $150.3 trillion through the end of 2021, according to the Fed. That's a whopping 37% increase over seven quarters and almost equal to the previous seven years combined. As impressive as that is, perhaps more encouraging is that net worth exceeds disposable income by more than 8 times, compared with about 4.5 times during the last inflation shock.
There's no doubt that much of the gains in excess savings and household wealth has been concentrated at the upper end; income and wealth inequality has only widened. And it's true that those at the lower end of the income spectrum are the ones hurt most by inflation. But here, too, may lie a silver lining. The government programs that put cash directly into the pockets of those who needed it most during the pandemic have ended. The thinking is that those who may have been able to stay out of the workforce thanks to government stimulus checks may be forced back in as inflation eats away at their savings. This may not be bad because it could help support that economy by filling the record 11.3 million jobs that businesses are trying to fill. In fact, it may already be happening.
The Labor Department said earlier this month that the labor force participation rate had its biggest two-month gain in January and February since mid-2020, when the economy was starting to open again after being abruptly shut down. And at 62.3%, the overall participation rate is just a couple of months away on its current trajectory from where it was in the years before the pandemic.
All of this is why Chris Watling, the chief executive officer and chief market strategist of Longview Economics, told Bloomberg Television that he puts the chance of a recession anytime soon at a slim 10% to 15%. “It's not my central case,” he said of a recession. “There is too much cash on the sidelines in terms of in people's bank accounts. Yes, we've had a bit of an oil price spike and we got a gas price spike and these are issues, but if you listen to what the CEOs of American banks are saying … people of all income levels have much more cash in the bank then they had pre-pandemic, so there is a cushion.”
The yield curve is one of the few things in financial markets that has attained mythical status for inverting before each of the past eight recessions. Impressive, but there's a big caveat, which is not every yield curve inversion has led to a recession. If 10-year yields fall below two-year ones again in coming weeks, this may be one of those times it sends a false signal.
More From Other Writers at Bloomberg Opinion:
- U.S. Business Leaders Place Bets on Prosperity: Matthew Winkler
- Stocks Walk on the Bright Side of the Road With Powell: Jonathan Levin
- The Fed Is Just Guessing About Interest Rates: Allison Schrager
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Robert Burgess is the executive editor for Bloomberg Opinion. He is the former global executive editor in charge of financial markets for Bloomberg News. As managing editor, he led the company's news coverage of credit markets during the global financial crisis.
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