South China Morning Post
Advertisement
Advertisement
A worker organises food at the West Alabama Food Bank in Northport, Alabama, on March 28. Inflation is driving up operating costs for food banks and pantries across the US and forcing them to ration their aid, but there are fears the Federal Reserve’s attempts to rein in inflation could lead to a recession. Photo: Bloomberg
Opinion
Macroscope
by Tai Hui
Macroscope
by Tai Hui

Is the US heading for a recession? There’s more to it than an inverted yield curve

  • Some investors fear the US economy is stalling, which could see the end of the equity market bull run
  • However, not only are there doubts about the yield curve’s ability to accurately predict a downturn, other indicators that monitor US recession risk remain healthy
Tai Hui
Tai Hui
Why you can trust SCMP
The US Federal Reserve increased interest rates at its March Federal Open Market Committee meeting, as well as its forecasts for inflation and policy rates. Senior officials have, since then, indicated that the focus will be on tackling inflation.

The market now expects a 50 basis point rate increase at the Fed’s next meeting in early May. This has heightened market concerns that aggressive policy tightening will not only reduce inflation but also economic growth.

The US Treasury yield curve has flattened significantly. By early April, the two-year bond yield was higher than the 10-year yield, a phenomenon known as an inverted yield curve. Historically, investors have seen this as a warning sign of slowing growth or even recession.

Given the inverted yield curve, some investors are sounding the alarm about the US economy stalling, which could bring the equity market bull run to an end. However, there’s no cause for panic. Not only are there doubts about the ability of the yield curve to accurately predict recessions, an inverted curve does not necessarily point towards an imminent downturn or equities bear market.

Hong Kong tech stocks extend decline as jitters about growth resurface

Let’s start with whether the yield curve is a reliable indicator of a rising risk of recession. Previously, the shape of the curve was thought to reflect the collective wisdom of bond investors on the economic cycle. When long-term interest rates are lower than short-term rates, it reflects a more pessimistic view of the economy in the long run, implying weaker growth or even a recession.
During the 2008 global financial crisis, major central banks around the world engaged in quantitative easing by purchasing government bonds and other financial assets. This was done again to address the economic consequences of the Covid-19 pandemic. The aim was to push bond yields lower and reduce the interest burden on businesses and households.

Changes in regulation since 2008 also saw financial institutions invest in government bonds to satisfy regulatory requirements. As a result, these bond investors are less sensitive to broader economic conditions and bond prices. Both central bank policy and financial institutions’ behaviour means bond yields are not as “clean” in reflecting investor expectations on growth and inflation.

There is another question on inflation expectations. We can broadly divide bond yields into inflation expectations and growth expectations. Given the current high levels of inflation and the market’s expectation that price rises will moderate in the coming years, this could partly explain the downward sloping curve, rather than it only predicting weaker growth.

02:47

As Hongkongers struggle with rising inflation, the city’s most vulnerable are the hardest hit

As Hongkongers struggle with rising inflation, the city’s most vulnerable are the hardest hit

Even before the introduction of these distortions to the bond market, a curve inversion did not translate into an immediate recession or sharp equity correction. In the past, an inverted yield was seen more as an alarm clock rather than a fire alarm. Investors still have time to generate returns from equities in the months following the inversion, rather than having to rush immediately for the exits.

There is no crystal ball to predict economic growth. The shape of the US Treasury yield curve was useful as an input in the past, but investors are now more sceptical of its reliability. And there are also other indicators to monitor recession risk in the US.

For example, business confidence and corporate borrowing costs are important drivers of business investment, which is a more volatile component in US economic growth. Hence, if business confidence starts to deteriorate or companies are paying more interest to borrow, corporate investment and hiring may slow.

Despite Ukraine crisis, global interest rates look set to rise

The same applies to banks’ willingness to lend. If commercial banks tighten lending standards, this will also weigh on business spending. Despite a more hawkish Fed, these indicators remain healthy, at least for now.

US economic growth may well decelerate in the coming months as the recovery from the pandemic is almost complete. Yet, there is sufficient momentum to keep the economy expanding in the quarters ahead.

Tai Hui is chief market strategist for the Asia-Pacific at JP Morgan Asset Management

12