With the normalisation of US monetary policy and evidence of an economic slowdown emanating from China, attention is turning to whether the United States can escape a recession. Indeed, the flattening of the Treasury yield curve often is cited as a potentially ominous sign. Over the past four decades, recessions invariably ensued whenever short-term interest rates rose above long-term rates. Figure 1 shows the often-cited recession metric - the yield differential between 10-year Treasury bonds and 2-year notes along with shading for recessions. Even a small inversion in this measure, such as the one that occurred in 2007, proved to be a precursor to the Global Financial Crisis. Granted, the lead time between inversion and the onset of recession has varied from about six months to one and a half years, but the consistent pattern begs the question of why this indicator has worked so well and whether investors should worry about a further flattening of the curve. Correlations, however, do not necessarily indicate causation, so it is worth asking why this relationship exists and as well as the broader question of why do economic expansions end.
At the time of this writing, the 2s/10s yield differential had shrunk to 18 basis points. The yield on 12-month bills actually has exceeded the yield on 5-year notes by a few basis points ever since the Federal Reserve raised its policy rate to 2.5% on December 19, 2018.
Figure 1: US Yield Curve: Inverted curve has been a good predictor of recessions
Imbalances and Recessions. Contrary to neoclassical theory in which economies supposedly settle into stable equilibriums, economic expansions always engender imbalances in either the real economy or the financial sector. Their origins often are rooted in the destabilising tendencies of business investment and the undisciplined and profligate nature of most governments. Businesses misjudge demand, overproduce and end up with too much inventory of unsold products, as now seems to be the case with European automakers and Chinese steel producers. Likewise, developers invariably build too many office buildings and resorts, while manufacturers invariably build too much capacity, as is the case in Asia today. Although technology and globalisation have mitigated those business blunders, the chain of events from boom to bust remains much the same – namely, it runs through the credit channel and eventually unsettles the financial system.
Financial imbalances, on the other hand, tend to be less transparent and more catastrophic than those in the real economy because they impair bank balance sheets and in turn undermine the availability of credit, which is the lifeblood of most economic activity. Although we are aware of the numerous pockets of unsustainable debt that smolders on bank and government balance sheets – from student debt and leveraged bank loans in the US to private wealth products and corporate debt in China to overleveraged real estate almost everywhere -- it often is difficult to anticipate when those smoldering debt piles will burst into flames. As long as lenders roll over debt obligations, defaults are suppressed. When circumstances change, however, and borrowers no longer can pay, banks tighten lending standards, and capital markets freeze up. Without short-term financing, economic activity withers.
The most often cited change in circumstances is when central banks belatedly tighten monetary conditions. Indeed, the perception that central banks cause recessions by raising interest rates is pervasive, even among professional economists and investors who should know better. A shrewder reading of history is that central banks set the stage for recessions by leaving monetary conditions too loose for too long. The plentiful flow of easy money during expansions breeds excesses in borrowing, leverage, government largesse and even fraud that come home to roost at the end of the business cycle.
Unwinding Quantitative Easing. In that context, western central banks face extraordinary challenges in unwinding their 10-year experiment with unconventional monetary policy that has left them with trillions of dollars of financial assets on their balance sheets and real policy rates still near zero. The Fed, as the first mover, will bear the brunt of these challenges for many reasons. First, Americans are led to believe that low interest rates are good for whatever ails the economy. This myth persists despite ample historical evidence that low interest rates in fact are destabilising once they no longer serve to stimulate domestic demand. That perverseness clearly has been the case over the past few years; according several studies, the effectiveness of QE has waned, while debt levels at home and abroad have continued to soar. Recall that the Federal Reserve’s foremost mandate is to mitigate systemic risk – a point that Chairman Powell has reiterated of late. Ultra-low real interest rates undermine this goal.
Second, the Fed’s policy of negative short-term interest rates clearly favoured banks and debtors at the expense of savers. The unfashionable phrase for these circumstances is ‘financial repression’. At full employment, financial repression of saving, which is the only sustainable source of funding for investment, is detrimental to long term growth. Indeed, the most common cause of recessions and financial crises is excessive consumption (either public or private) at full employment; the inevitable overheating and debt accumulation prove to be the Achilles Heel of expansions. In that context, the huge tax cuts enacted in early 2018 were a giant step in the wrong direction.
Most members of the FOMC seem to recognise this dilemma with two subtle changes in their latest outlook at the December FOMC meeting. First, the median forecast for inflation was lowered to match the Fed’s target rate of 2%, implying they did not anticipate the need for overshooting on the policy rate. Second the median long-term growth rate, which is tantamount to their estimate of potential growth, was raised to 1.9%, or closer in line with projected real GDP growth. And third, the central tendency for the fed funds rate in the long term declined to 2.75%, or little different from the current level of 2.5%.
Why the Yield Curve Works – or Not. Consider then the implications of short-term rates remaining at or below 3% for an extended period. In the usual recession scenario, the Fed raises its policy rate to the point where bank lending is either unprofitable or unwise. When that happens, banks invariably tighten lending standards, some of the less worthy borrowers struggle to obtain funding, and activity is constrained. To be clear, this ‘cleansing’ of debtors is a prerequisite for the next expansion; procrastination or life support, both of which waste valuable financial resources, simply delay the day of reckoning and make recessions longer and deeper.
Now consider then the implications of short-term rates remaining at or below 3% for an extended period, which is the Fed’s current outlook. Namely, the Fed expects short-term rate instruments, like commercial paper and overnight loans that are the main sources of funding for banks, to remain well below the current prime lending offered to commercial banks’ best customer – now 5-1/2%. Because the Federal Reserve has moved so gradually and predictably in raising short-term rates from very low levels, banks have been able to raise lending rates slowly as well, thereby maintaining ample margins on loans. In fact, loan margins have been at historic highs ever since the Fed lowered its policy rate to zero in the wake of the Global Financial Crisis (see Figure 2). Banks tend to follow the Fed in adjusting lending rates to the cost of short-funding, albeit with some delay (i.e. banks mark up prices over costs), except at very low interest rates. This pricing behaviour implies that the Fed uses its policy rate in part as a tool for restoring banks’ balance sheets during times of stress as well as the converse - a means to cool off lending that threatens to overheat the economy.
Figure 2: Bank Loan Margins
That cyclical margin on loans is why an inverted yield curve is not necessarily a good predictor of recessions at very low interest rates. The Fed would have to raise the cost of borrowing above 5% to make loans unprofitable, and hence warrant tighter lending standards, whereas FOMC members now project the neutral policy rate at less than 3%. In short, an inversion of the yield curve enough to curtail lending does not seem likely anytime soon. Moreover, the Fed’s gradualism and predictability in recent years also has translated into a very gradual and manageable increase in borrowing costs. Indeed, the notion that Fed policy somehow has been destabilising or damaging to the real economy because interest rates have risen from very low levels is pure foolishness. Normalisation of the Fed’s balance sheet, on the other hand, has become problematic because it is on a collision course with the horrendous US budget deficit.
The End Game. Banks do tighten lending standards for other reasons, of course. Borrowers become too big a risk for a host of reasons, ranging from debt burdens being too great to cash flows being too little. I expect to see a rise in loan defaults and delinquencies in the years ahead. Yet, neither of those warning signs have reared their ugly heads. So, banks have had little reason to cut back on corporate or household lending, and in fact have been relaxing lending standards on balance over the past year (see Figure 3). That virtuous circle is destined to end, especially with signs of a global slowdown spreading. In that context, it is worth contemplating the root causes of what is weighing down global growth – namely, an unprecedented overhang in income and wealth inequality that has created a savings glut, soaring debt levels that will drain cash flows, imposition of tariffs and other conflicts that hinder global trade and pose barriers to capital mobility, and the dearth of value-adding investment opportunities in a world besot with excess capacity and political gamesmanship. These failings, most of which are self-inflicted, are weighing on the world economy and ultimately will come to haunt the financial sector.