Markets are jittery to say the least. They crashed last week in response to China’s yuan devaluation and then, without any further substantive news, made a complete recovery during the next few days. Such moves surely speak to nerves. More recently, stocks have crashed on news that economies in Germany and the United Kingdom might have contracted and that the yield on the 2-year Treasury note exceeds the yield on the 10-year bond. Weakness abroad is never good news, and such yield-curve inversions are considered a classic signal of an impending recession.
Investors should look for recession. This recovery has lasted longer than others and low rates of unemployment suggest that there is limited labor fuel for continued growth. Prospects of trade war also present risks. But still, there is good reason for skepticism about whether these two events signal an immanent economic turn, as some have suggested, or justify panicked sales. Even if one can accept the yield-curve signal uncritically, the classic relationship would suggest that economic trouble would arrive only after 9-12 months.
For one, the recent news – about the European economies or the yield curve — is hardly new. All market participants have known for some time that Europe’s economies are weak. The difference between stagnation and a modest downturn may have technical value, but it hardly offers a new insight into the situation.
Second, the flat-to-inverted yield cure has been a subject of conversation for some weeks. I wrote in the subject almost three months ago. There I tried to offer several perspectives on the indicator. This is no time to repeat that entire analysis, but two conclusions might have an immediate use: One is that the present inversion may reflect economics less than how negative yields abroad are driving an inordinate amount of foreign funds into longer-term U.S. Treasury bonds. The second thing to note is that yield curve inversions have given false recession signal in the past. Some recessions arrive without the signal and not all signals are followed by a recession. The joke among business economists is that yield curve inversions have forecast seven of the last five recessions.
If these considerations suggest little need for the panic recently exhibited by investors, all nonetheless should remain alert to recessionary signs. Japan’s and Europe’s economies are weak. China has slowed, too. The United States can hardly continue growing alone for an indefinite period. Either these foreign economies will pick up or they will in time drag this country’s economy down. If yield curve inversions are not the foolproof indicator implied by some recent media reports, neither are they something investors should dismiss. Inversions should make all especially sensitive to corroborating evidence of economic weakness. Panic, however, is never useful.
Milton Ezrati, Contributor