Yield Curve Business Cycle Indicator Says No Recession Imminent
The history of Fed rate hike cycles and recessions are clear. The FOMC causes every recession by fighting inflation—it’s their mandate. So what makes them think this time they can generate a soft landing with the most complicated combination of debt, demographics and geopolitics we’ve seen along with a wave of cost push inflation not seen in 40-50 years? We suspect, the simple fact that if they told you what they really think, the stock market wouldn’t like it very much. And they care about financial conditions. The first chart shows the US 3-month (green) and 10-year (orange) yields along with the shaded periods when the US economy was in recession. We always see the yield curve (3M-10Y) invert before a recession. We are a very long way from that today. Based on the most recent Fed forecast we saw last week, the curve could invert in early 2023 suggesting the recession would be a 2024 or 2025 impact. The next few years for the stock markets may be a challenge.
When we look at the yield curve, we do this because it directly impacts bank profitability. All should know, that falling rates are generally negative for net interest margins (NIM). Banks borrow short and lend long as a general rule. The lower the NIM, the more risk adverse banks get, which leads to less credit in the market and ultimately lower growth rates.
The cause of inflation stress today has little to do with the traditional business cycle, raising rates are NOT LIKELY going to generate a soft landing. The economy is far more fragile from a credit perspective making the inflation fighting effort more complicated. But bank balance sheets are in good shape and systemic risk is low. But rates will not likely be able to rise too much. We had better hope that inflation is not too sticky.
The National Association of Business Economists (NABE) recent survey U.S. inflation will likely exceed 3% through the end of next year, according the majority of economists surveyed by NABE. Some 78% of panelists see 3% or more annual growth in consumer prices, with 36% of forecasters indicating that inflation is “very likely” to stay above that level. Meanwhile, 77% of panelists said that monetary policy is too stimulative. The NABE survey was conducted before the Federal Reserve raised interest rates last week for the first time since 2018, but that decision was widely anticipated. The survey of 234 NABE members was conducted March 1-8. This is way above the Fed’s forecast, which puts them WAY behind the curve.
A look at the trailing NIM for select US and the top 5 Canadian banks shows current NIMs are the lowest we have seen in decades. The odds that the FOMC does not have the tools to generate a soft landing is very high.
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