Are We Headed Toward a Recession?

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Are We Headed Toward a Recession?

Image credit: USA Today

Image credit: USA Today

Image credit: USA Today

Image credit: USA Today

Jonah Woolley, Politics Writer

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Recently, there have been rumbles that a recession is coming.

There are polls showing that a large number of economists believe a recession is on the horizon, reports of slowing economic growth, articles about how to prepare yourself for a bad economy, and even mentions of an “inverted yield curve” and how it means a downturn is inevitable.

It’s a mess of economic talk, criss-crossing evidence, and conflicting opinions, and for a lay person, it’s hard to make sense of it all. This is an examination of whether it’s all smoke and noise, or if we really have something to worry about.

What’s an inverted yield curve?

If you’ve been paying attention to the news for the past couple weeks, you’ve likely heard about the inverted yield curve and how it means a recession is coming. For most people, however, it’s still not clear what it really is and why it means a recession, so that should be explained first.

The inverted yield curve relates to US Treasury bonds, which are loans the government gets from investors that are used to pay for government projects that aren’t covered by taxes.

These loans are important for a variety of reasons—they stimulate the economy, they give the government money for its various projects, and they affect the prices of other types of loans, including mortgages.

Like all loans, government bonds have interest, and the interest rate on a bond is known as its yield. The amount of interest on these bonds can have ripple effects throughout the economy. Low interest rates on government bonds can mean lower rates on other kinds of loans, which leads to more economic development, while high interest rates on bonds can be used to combat inflation and moderate economic development.

The yield curve involves how the interest rates of government bonds relate to each other. There are many different kinds of government bonds that are paid out over varying lengths of time, including 3-month, 6-month, 1-year, 2-year, 10-year, and 30-year bonds.

In a normal yield curve, the interest rates on short-term bonds are lower than those of long-term bonds. This is because the long-term bonds are a higher risk; they force investors to lock down their money for a long period of time and miss out on other possible investments. To get investors to bite, then, the government has to offer higher interest.

Source: CNBC

On August 14th, however, the interest rate on the 2-year bond became higher than the interest rate on the 10-year bond. This was a reversal of the normal yield curve—an inverted yield curve—and it has become a significant source of concern over the state of the economy in the past two weeks.

Short-term rates going higher than long-term rates means that investors think long-term bonds are a lower risk, and they tend to think that because they think the economy is about to go downhill. In a declining economy, if they got a short-term bond, while it might get paid off, there won’t be good opportunities for reinvestment after the short period. With the long-term bond, however, they lock in a higher current interest rates and get to keep them throughout the incoming downturn.

Essentially, when the yield curve inverts, it’s a sign of investor anxiety.

This specific inverted yield curve, with the 2-year bond having a higher interest rate than the 10-year bond, is an especially alarming one. The inversion of these two rates has preceded each of the 7 most recent recessions, with a downturn occurring an average of 22 months after the initial inversion.

The inverted yield curve is already sending jitters through other parts of the economy. On August 14th, after the interest rates inverted, the Dow Jones stock index experienced an 800 point drop, one of the largest in Wall Street history, and other stock indexes like the S&P 500 and Nasdaq experienced similar drops

Now, it appears that in most discussions of a recession, this is where the conversation ends. The inverted yield curve happened, it meant a recession before so it must mean one now, so let’s just bury our heads in the sand and wait for the recession to come.

This doesn’t have to be our approach. While the inverted yield curve certainly is a sign of concern, it doesn’t guarantee a recession. There have been false alarms before, and the inversion doesn’t cause a recession on its own, it just signals that investors are unsure about the economy.

Investors do have good insight into the economy, which is why this shouldn’t be taken lightly, and economists have echoed their fears. Julia Coronado of Macropolicy Perspectives said there’s a 40% chance of an economic downturn in the next 12 months, and according to a survey by the National Association for Business Economics, nearly 4 in 10 economists agree with her.

However, it’s not set in stone. Many economists, including Victor Shvets of Macquarie Commodities and Global Markets, have made convincing arguments for why the inverted yield curve doesn’t necessarily mean a recession. Shvets asserts that the yield curve is a result of 3 factors: 

  1. Companies having more difficulty buying and selling assets;
  2. Lower amounts of activity to stimulate the economy like reduced taxes and government projects; and
  3. A decrease in international trade and partnerships between businesses

According to him, these factors do have the potential to cause a recession, but only if they are ignored. The inverted yield curve was a sign that we have to fix those problems, and if we do, we can avoid downturn.

Other economists have pointed out that the problem isn’t as bad as it’s been portrayed by the media. The inverted yield curve we experienced on August 14th lasted less than a day, while the inversions that lead to previous recessions lasted much longer. The inverted yield curve that preceded the recession in 1998 lasted 27 days, for instance.

Many of the immediate economic impacts we experienced from the inverted yield curve were mitigated very quickly: the stock market recovered over half its drop following the inversion by the end of the week, and there were other good economic signs, like a strong retail sales report, that came out mere days after the inverted yield curve occurred.

Also, in the face of the inverted yield curve, steps have already been taken to combat a recession. Writing in an op-ed for Bloomberg, economist Tim Duy argued that the reason the inverted yield curve has been such a good recession predictor in the past is because it was mostly ignored by the federal government.

In the past, whenever an inversion would occur, the Federal Reserve would still be concerned with inflation, so they’d continue to raise interest rates and ignore the economic activities they could do to stop a recession. The sequence of raising rates after an inversion has often preceded a recession.

This time around, however, the Fed hasn’t made the same mistake. Instead of raising rates, it cut them by a quarter of a percent in July, which was seen as a good way to spur economic growth and stop a recession. They have also made plans to cut rates again in September, possibly by up to a full percentage point.

Because the Fed is acting more appropriately, Duy argues, it’s a lot less likely that this inverted yield curve is predicting a recession.

All in all, it’s kind of a mixed bag. The inverted yield curve certainly has meant danger before, and it shouldn’t be ignored now, but it also doesn’t mean a recession is inevitable. There are many steps we can take to stop a recession, and the Fed has already begun to take some of them.

With that out of the way, we need to look past the inverted yield curve. While it has received significant coverage, it isn’t the be-all-end-all, and there are a lot of other indicators economists look at to see if a recession is looming that we need to discuss.

Indicators of a Recession

  1. High unemployment

Unemployment is a pretty clear sign of an economic downturn. Whenever the economy is headed downhill, companies start to lay off workers to cut costs, and if you see a sudden spike in unemployment, that means the economy is doing poorly.

The rule of thumb a lot of economists follow is that a recession is coming if unemployment is three tenths of a percentage point higher than the 12-month low. In July, unemployment was 3.7%, only a tenth of a percentage point higher than the 12-month low of 3.6%, which occurred in June.

Another unemployment aspect economists look at is hiring rates for temporary workers. Temporary workers are employees who are hired for a limited time by companies that have too much work for their traditional workforce.

If companies are hiring a lot of temporary workers, it’s a sign the economy is strong as they’re getting a lot of work, and conversely, if companies aren’t hiring temporary workers, it means the economy is going down.

This year, hiring rates for temporary workers was 4% lower than previous years, which indicates that the economy is trending slightly down.

  1. Low consumer confidence

Consumer spending is what drives the economy. Businesses can only make money when consumers buy their products, so the economy does well when consumers are more confident.

When consumer confidence drops, however, it means they can become more stingy with their spending and that can result in an economic downturn.

The Conference Board produces an index on consumer confidence that’s frequently referenced by economists, and a 15% drop in the index is seen as indicating a recession. Currently, the index has been going strong, with consumer confidence reaching an 18-year peak in July.

  1. Low manufacturing activity

Manufacturing is another relatively accurate predictor of economic downturn. It’s an industry that produces products that require big purchases, such as cars, and when the economy is bad, those big purchases are the first thing consumers skip over.

Therefore, if manufacturing activity goes down, it means consumers are buying fewer of their products and the economy is headed down.

The Institute for Supply Management’s index of manufacturing activity recently read just above 50, meaning that manufacturing is growing, but that growth is quite slow. While this isn’t ideal, the index is still above the 45 that it reads whenever a recession is coming.

  1. A bad stock market

The stock market is the telltale sign of the health of an economy. When it goes down, it means investors and businesses lose a lot of money, resulting in a downturn, and when it goes up, it means investors and businesses have a lot of extra money they can use to invest in development and stimulate the economy.

As mentioned earlier, stocks took a significant hit following the inverted yield curve, with the Dow falling 800 points, and overall, stocks have been going slightly downhill recently.

The 3 major stock indexes – the Dow Jones, S&P 500 and Nasdaq – have all been on the decline since mid-July; however, their declines haven’t been significant enough to indicate a recession. Economists agree that the stock market needs to be trending downward for 508 days or have declined by 20% for it to mean a recession.

The declines of the major stock indexes have not been long enough or significant enough to indicate an economic downturn, and looking at the big picture, the stock market is still quite strong. The 50-day and 200-day average stock prices on the stock indexes, which are used by investors to tell how the market is trending, have been going upwards even during the inverted yield curve.

So, with stocks, the picture is quite bright. There was a blip on the radar caused by the inverted yield curve, but it hasn’t continued long enough to be of major concern, and in general the market is still quite good, so a recession seems unlikely.

  1. A weak housing market

Like manufacturing, housing is a good tell of consumer strength. Houses are major purchases; in a good economy, consumers are able to purchase larger houses, but in a weak one, they’re less likely to purchase a house.

According to Bloomberg, in July the number of housing starts, or houses being constructed, were down by 4%, and in general the housing market has been fairly weak. It’s been in a narrow growth range, and that range is towards the lower end of what it typically is. The housing market has also been declining for the last three months, although mortgages remain easy to get.

The Media’s Role in Reporting the Recession

Looking at the overall picture of the economy, a recession doesn’t seem imminent. There are some downward signs in some areas of the economy, but in general the economy has been doing fairly well. The only thing significantly out of the ordinary was the inverted yield curve, and even that wasn’t severe enough to indicate a recession.

The truth is, the biggest risk of us having a recession isn’t any of the economic indicators—it’s us talking about a recession.

According to the Chairman of Banking of America, Brian Moynihan, the current state of the US economy is fine. There have been some slight bumps in foreign markets (some caused by Trump’s trade wars), like negative GDP growth in Germany and a decline in manufacturing in China, but those haven’t been enough to cause any significant harm.

The economy is still doing quite well, but whenever one of these bumps occurs, the media reports it like it’s the end of the world. If you look at the media’s reports on the inverted yield curve, most of them talk about how it indicates a recession as if it’s inevitable, and they don’t discuss any of the positive or neutral signals the economy has been sending off.

When we’re getting all this doom and gloom information, it starts to impact us. Thanks to a lot of the reporting, more and more people are likely to start thinking a recession is coming, and that will affect consumer confidence. The hit consumer confidence will take if this coverage continues will be the real catalyst for a recession.

Therefore, the news needs to be more careful with how they discuss the state of the economy. Looking at the big picture, things are going well, and reporting on a singular quirk in the economy as if the sky is falling down is only going to make matters worse.

There’s a great responsibility in economic reporting now, and that should be taken seriously. The media is welcome to report on the inverted yield curve, and everything else going on in the economy, but they should also be willing to report all sides, to give the proper nuance to what is happening, even if it doesn’t grab as many headlines.

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