Don't count out the yield curve

An inverted yield curve has long been a reliable indicator of recessions—tested and verified over the past 50 years. Typically, a recession arrives around a year after the yield of the 2-year U.S. Treasury note first exceeds that of the 10-year. Yet, its inversion since June 2022 has not led to even much of a slowdown. That’s 24 months and counting. Recent data shows a softening but resilient economy, in which weakness in one sector is largely offset by strength in others.  

So, what is different this time around? Has the yield curve lost its power as a guidepost, or the Federal Reserve solved the puzzle? Or has the cycle simply been extended, and a recession is still on the way? A few reasons why the latter might still be the case:

• The pandemic period distorted several indicators and patterns as shortages and excesses drove consumption. In the ensuing years, disruption in supply chains led to hoarding and then revenge spending as the world re-opened. The labor market faced a shortage of workers and new attitudes about work, seen in higher quits rates, job switching and demand for flexibility. Many aspects, such as consumer behavior and employment have been normalizing, but aren’t there yet—witness the strength of the July retail report.
• The refusal of the economy to stop while the yield curve is flashing yellow could have much to do with the Fed’s extraordinary more-than-a-decade of zero-rate monetary policy. Graduate students and economists will study that period for decades to come, but it’s likely that it muted the impact of the Fed’s aggressive tightening cycle. The low-to-no cost borrowing led to artificially healthy balance sheets, mitigating the need for new borrowing, so the impact of higher rates is taking longer to manifest.
• Perhaps most significant is the Fed’s commitment to transparency. Since the GFC, the FOMC has layered in forward guidance in its post-meeting statement, added a press conference and provided a Summary of Economic Projections, headlined by the dot plot. But the enhanced communication limits the need for the markets to infer future moves, essentially directing the shape of the yield curve. The curve is parroting the Fed, not projecting.

Any or all of these reasons, and surely others, could explain why the incredible spike of the fed funds rate—at 550 basis points the steepest and fastest ramp-up in rates in history—has not tanked the economy. But the way Fed Chair Jerome Powell has guided the markets is telling, the latest example leading to a consensus for a cut in September.  

And that’s where we find ourselves: still asking if a soft landing is possible or a recession is the necessary outcome of a Fed hiking cycle. We may not know the answer for many more months, or longer if we wait for the NBER to designate it. But in this case, the inverted yield curve’s reliability as a signal has been weakened.