The inverted yield curve means that a recession is still likely, the indicator’s inventor wrote this week.  
However, excessive labor demand, a stronger housing market, are factors that will dampen the impact. 
The economist said the Fed is misreading inflation and should cut rates immediately.

The inverted yield curve has been flashing red for 15 months, but don’t think that ongoing economic strength makes it a false signal, Campbell Harvey wrote in a Research Affiliates note.

Harvey is known for discovering the most popular recession indicator, which shows that when yields on short-term Treasury bills move above those on longer-dated bonds, a downturn will soon follow.  

As this has proven true for every recession since the 1960s, the current inversion signals that a downturn is still likely this year, but a few factors will limit the scope of an impending slowdown, helping the US achieve a soft landing.

“Given the track record of the yield indicator, it is with great peril to ignore it,” the Duke University economist said. “The yield curve indicator suggests growth will substantially slow in 2024. This slow growth may or may not be associated with a recession. Even in the soft landing scenario, there is a chance for a minor recession.” 

First off, excessive labor demand makes a deep recession unrealistic. With a massive gap between job openings and job seekers, roughly at 2.5 million, unemployment won’t immediately surge when the economy starts to cool down. With more workers holding onto their jobs, consumer spending levels will stay robust.

Meanwhile, strength in today’s housing market will stave off a foreclosure crisis that accompanied the 2008 recession, during which excessive debt levels meant many homeowners owed more than their house was worth. 

This time around, housing market equity is higher than mortgage debt thanks in part to massive price appreciation that took place during the pandemic. Americans at the end of 2023 were sitting on $30 trillion of home equity versus $17 trillion in mortgage debt outstanding. 

On the business side, past experience with the inverted yield curve has led entities to take preventive action when Treasury rates flip. Through 2023, business investment retreated, while some implemented labor force reductions.

“Companies that become leaner have a much better chance of surviving an economic slowdown. This risk management dampens the volatility of the business cycle which is a good outcome,” Harvey wrote.

Still, it’s unclear where the US economy is headed. In Harvey’s view, the Federal Reserve added to recession risks by pushing interest rates too far. That’s as the central bank is misreading inflation reports, he said, as shelter inflation is realistically lower than reported. 

If recalculated, the year-to-year consumer price index is below the Fed’s 2% target rate. 

“To me, the most effective mitigant for the recession scenario is for the Fed to quickly reverse course. Ideally, the Fed Funds rate is 3.5% by year end (from 5.25% today) and the cuts should start immediately.”

Read the original article on Business Insider

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