The US economy has avoided slipping into recession all year, but one closely watched indicator shows it's on the brink.
Usually, yields on longer-maturity bonds exceed those of shorter ones. An inverted yield curve happens when the reverse occurs.
Some track the spread between 2-year and 10-year Treasury notes for signs of an inverted yield curve. But Canadian economist Campbell Harvey's definition uses the difference between three-month bills and 10-year notes, a spread which turned negative in November 2022. It's a perfect 8-for-8 in predicting every recession since World War II.
The amount of time it takes after the inversion for the economy to fall into a recession can vary. The past four recessions occurred when the spread between the two yields narrowed and came close to reverting back to normal. That is what is happening now.
"I've become a bit more pessimistic since August," Harvey, a Duke professor who created the indicator, told Yahoo Finance.
Harvey had previously called for the Federal Reserve to stop hiking interest rates and believes any additional hikes throughout 2023 will cause "significant" stress.
"[Monetary tightening from the Fed] operates with a lag and we just don't see it right now," Harvey said.
Read more: What the Fed rate-hike pause means for bank accounts, CDs, loans, and credit cards
To Harvey, the reason the yield curve inversion is close to normalizing is the most concerning.
There are two ways for the inversion to unwind. One is when short-term yields, which closely follow the fed funds rate, drop quickly, bringing the 3-month yield below the 10-year and therefore ending the inversion. This movement, known as a bull steepening, often happens just before the Federal Reserve cuts interest rates.
But the current market has seen a different scenario, known as a bear steepening. This is when a rise in the 10-year yield causes the curve to revert back to its usual positioning with short-term rates yielding less than long-term rates.
The problem with that path is that consumers and businesses are then left with the highest long-term interest rates in about 16 years.
"The long rate is much more important than the short rate because the longer rate is more aligned with business decisions, in terms of investment," Harvey said. "When you're making an investment, it's not usually a 90-day investment. It's a longer-term investment. It can be three [years], five years, or even longer."
The impact of those higher longer-term rates is already playing out in the market. Mortgage rates, which often move with long rates, are at their highest level in 23 years. Credit card delinquencies are piling up. And the cost to borrow capital is increasing, particularly weighing on companies in the Russell 2000 whose debt matures in the next few years.
Rate-sensitive sectors like Real Estate (XLRE) and Utilities (XLU) have seen the biggest sector declines this year.
Harvey doesn't just think the rise in long bond yields will be bad for certain areas of the stock market, either. He, like other economists, sees the lagging impacts of the tightening financial conditions eventually slowing down the American consumer and sending the US economy into a recession.
"We still think consumer spending is set to weaken as higher gas prices, the resumption of student debt payments, and a slowing labor market weaken growth in disposable income," Oxford Economics team of economists wrote in a recent research report defending their call for a recession in the coming months. "Higher interest rates and tighter lending conditions will hit rate-sensitive spending into year-end."
Josh Schafer is a reporter for Yahoo Finance.
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