How Close Are We To A Recession? Published on Apr 12, 2023
Is this the first false positive since 1955?
Several articles have been popping up recently showing that there is a recession coming up; in some cases, they refer to a recession worse than the financial crisis in 2007-2008. But other reports show that the market is nowhere near a recession as major companies’ earnings are up-trending and relieving investors.
The contagion reports are backed up by an indicator that hasn’t been wrong since 1955. We are talking about the yield curve, a single line that plots the return we expect to receive from an investment in US Government bonds for every maturity and how its shape predicts the upcoming recession.
The model created by the Canadian economist Harvey Campbell has been detecting recessions since 1955. Every single time the yield curve has been inverted, a recession follows.
Before we explain the inverted yield curve, let us discuss the value of time and money. We understand that inflation takes a toll on your money. The money you had a decade ago doesn’t have the same purchasing power as today. This is why people expect to receive interest on their money over the years to maintain their purchasing power.
Knowing all of that and given the tight relationship between the interest rate and inflation, the short-term interest rate is higher than the long-term interest rate, with the one-year yield being around 4.85% and the 10-year yield being around 3.40%. This is not the regular case; this is why it’s called an inverted yield curve.
Who is affected the most by this shape of the curve? People who owe money in the short term will pay higher interest, and those who have investments will receive money in the long term, which is currently the lower rate. This will provide a negative return on investment. The banks fit this criteria. The bank pays clients on short-term deposits, as clients usually lock their money up for a couple of months or, at max, a few years. Based on the lower long-term yield, the bank’s income will be based on long-term loans, mortgages, bonds, and other financing methods. So, Banks are paying high for short-term deposits and receiving low for long-term loans, significantly affecting their profit and liquidity.
Every time the yield curve gets inverted, a recession will shortly follow. However, projected company earnings are up-trending, inflation is declining, increase in employment, and market sentiment is improving. All these reasons validate that this might be the first time this model might be invalid.
Only time will tell, so buckle up!