Inverted Yield Curve? America Headed for Recession? No Chance

Much of the media is like a child stamping and crying aloud, because what they hear is not what they want to hear. Nowhere is this more obvious than in economics. Many Democrats want a recession in 2020.  They will be disappointed.

A recent NBC story was all Eeyore, pessimistic and hoping on a downturn for 2020.  How else can they beat President Trump?  The headline:  “Markets are flashing this warning of an impending recession – but when?”  Yes, when indeed?

The story argued, “a key metric that historically has been a precursor to a recession emerged on Friday, reinforcing fears on Wall Street…” The metric is the “inverted yield curve,” which signals borrowing costs on short-term debt exceed costs on the same debt instruments in the long term. 

True, that recently happened.  Short term debt costs exceeded longer term debt costs.  In other words, interest rates went down over time, rather than up.  The basic inference from the inverted (or negative) yield curve is that investors expect lower growth in the future, thus agree to lower rates later.  

The idea has currency.  In a normal (more or less free) market economy, the inversion suggests falling confidence in an economy’s future, which may be based on objective evaluation or purely psychological, but often precedes a recession. 

But this is a misreading of the moment, and some investors realize it. Why a misreading?  Here is why. 

First, interest rates are affected by many factors – more each year, a plethora of variables in the Trump years.  For example, current interest rates may be higher due to atypical risk – a pending deal with China that may be super or could fizzle, a sudden cutting of Great Britain from the European Union or maybe no Brexit, fissures in NATO or total harmony, new oil drilling and fracking or judicial intervention to stop it, disrupted trade with Mexico or steady sailing.

To these variables, add new nominations to the Federal Reserve – Trump loyalists.  Add conflicting signals surrounding a one-year interest rate pause – with some hoping for rate cuts to get ahead of the infamous inverted curve.  Add possible political cross-currents as Democrats push socialism, and Republicans murmur about new tax cuts, ending the inefficiencies in Obamacare, streamlining Medicaid.

In short, the level of potential volatility is high, with no end in sight – but most indicators are highly positive, from GDP growth and unemployment to low inflation and consumer confidence – which means risk-taking investors are paying full freight right now, for their debt.

Put differently, the “normal yield curve” is upward or positive, as it rewards people for holding onto investments for a longer period of time.  This is because more time usually involves absorbing more risk.  But not always.  

That is not happening now.  More accurately – it may be happening, but is masked by volatility, which is overshadowing longer term risks.  The effect is that short-term interest rates are temporarily higher than longer term rates.  

Now, turn the page.  Ask what does the “longer term” look like, right now?  Why would holding debt for a longer time be less risky than investing in the short term?  Why would anyone get less compensation for holding debt a longer time? 

One reason – usually not in play – is the expectation of steady or falling inflation over time.  If the real value of a dollar is predicted to stay steady or grow – based on a powerful US economy, incremental gains in labor productivity and wage growth, then holding debt over time is profitable at low interest rates.  In other words, no need to worry about inflation, if the dollar is granite – which it is.

Another reason for low long-term rates is that investors may believe we have a “new normal” interest rate – that is, the magic spot where highest employment matches lowest inflation.  Some think this rate has been found or could be even be lower than the current rate set by the Federal Reserve.  If that were true, high growth America would see no rate increase for a very long time. 

A final thought counters the media negativity about America’s booming economy.  The NBC story quotes a leading economist calling the inverted yield curve “a dangerous and upsetting harbinger of the future of the economy,” to which he adds blah-blah about a pending recession.  Horse manure, if I may coin a phrase. 

Nowhere do any of these economists explain what most consumers know – all indicia of continued growth and a booming economy are full-throttle up, except international and political factors that economists find mystifying, hard to predict, and so despise.  Politics is replete with uncertainty; economists cannot factor it.

Let’s get real.  While the China deal is not yet done, leaks and logic point to deal completion – perhaps in phases – during 2019.  Europe will survive Brexit, NATO will hold together, nuclear war with North Korea is not likely, Mexico has a vested interest in cooperation, and the Federal Reserve – even before Trump nominees – is not likely to raise rates until 2020, if then. 

So, what is this inverted yield paranoia?  What is the glass half-empty business?  Why would anyone take the best data in generations, and infer from it that the sky is falling – or about to fall? 

Three reasons. 

First, professional economists are flummoxed by Donald Trump’s unwavering confidence in the US economy, in average Americans’ power to grow that economy with work, and in their confidence in his confidence in them.  That’s a mouthful, but true.  In a phrase: Economists often do not get it.

Second, economists live in a world that does not explain anything; rather, it describes things and then tries to predict. Thus, the famous Phillips Curve describes a perfect trade-off between lower unemployment (i.e. higher employment) and wage inflation: More jobs, higher inflation; fewer jobs, lower inflation. 

Only that curve fell flat – first with Ronald Reagan, then with Donald Trump.   Inflation is quite low, yet we have the highest employment – that is, lowest unemployment – in decades.  In many demographics, we have the lowest unemployment ever recorded.  Oops.  Poof goes the curve.

Same is true with the magical inverted yield curve.  Turns out, competing interest rates are buffeted by other factors, too many for technical prediction.  There are too many variables in the robust economy of Donald Trump to make the yield curve useful in predicting anything –including recession.  Reality trumps theory.

Finally, Democrats are unhappy, as are friends in the media and academia.  Good news does not sell – or get new presidents elected.  There is no Russia collusion, is no obvious candidate to beat Trump, no joy in an economy realigning Democrats with Trump. 

The Democrats best hope for 2020 is a good, disaffecting recession.  Bottom line:  They just lost that chance too, since last week – no kidding – even the yield curve turned up, inversion is gone.  Poof.  What is the world coming to?  Too much good.