I Will Be Your Predictor

by | Jun 10, 2024 | Risk Report | 0 comments

The Risk Report is always excited to dive into news details that validate what it already believes to be true. And if it can be combined with topical lyrics from Queen Bey, it is even better.

So, remember the yield curve? The one by all measures has been inverted for a while now. The one we always thought was a nice indicator of a recession coming. The one that lately seems to have lost its power. Well, WSJ brought a noteworthy and illuminating piece about it*.

Back in 1986, when Beyoncé was just five years old, Campbell Harvey wrote in his Ph.D. thesis that when short-term rates are higher than long-term rates it is a harbinger of economic depression, and history has (largely) proven him right.

It kind of makes sense because the downward-sloping yield curve shows a market expectation that the Fed will lower interest rates to get the economy going, and the Fed obviously only needs to do that when it is not (going, that is.)

So, what does it say? Recession is coming! When does it say? In nine to 24 months!

And therein lies the rub. We are now at the end of month 23 since the yield curve went topsy-turvy and it doesn’t really seem like there are any White Walkers on the horizon.

Also, as of publishing time, the Fed has yet to lower rates (though it might be coming sooner rather than later now that Bank of Canada and ECB started the party.)

In fact, all numbers point towards clear and sunny skies. Do we just wait a little longer or should we accept that we might be looking at the wrong numbers and this predictor-thingy is broken?

First of all, normal predicts normal and these times might not be normal. We have just gone through a series of never-before-in-recorded-time shocks to the global economy. It wouldn’t be beyond the realm of possibility if the metrics we used in much less volatile situations couldn’t be applied to this.

Second of all, if you look closely at the graphs there were already signs of metric weakness back in 2006, and that was more than 15 years, two global crises, and a whole lot of financial innovation ago. Maybe the era of yield curve foretelling has long passed, and we just haven’t noticed because it hasn’t been inverted until now.

The economy has evolved, and monetary policy tools have (had) to evolve with it. Apparently, now we can have high rates without unemployment going up or inflation rushing down. As The Risk Report has outlined in the past weeks, that is not the same as high rates aren’t painful, more that economic transmission channels have multiplied beyond.

In other words, what we thought to be stylized facts might neither be stylized nor facts anymore.

As Ms. Carter says:

Nothin’ really is

For things to stay the same, they have to change again

*The main source of this post and its graphics is the WSJ article “Wall Street’s Favorite Recession Indicator Is in a Slump of Its Own” from May 28th, 2024.

Regitze Ladekarl, FRM, is FRG’s Director of Company Intelligence. She has 25-plus years of experience where finance meets technology.