Is the economic tide about turn?

While many of us will be at the beach to celebrate the 4th of July, economists will ponder whether our economy is at, or near, high tide and when that tide might turn. According to the National Bureau of Economic Research, the U.S. economy has now entered its 10th year (109th month) of growth. The current economic expansion began in June 2009 and is now the second-longest expansion on record. It is only exceeded by the expansion from March 1991 to March 2001, which lasted a full 10 years (120 months). NBER’s records go back to December 1854; from then to now, its records show the U.S. economy has experienced 66 business cycles. A business cycle includes an economic expansion and a subsequent contraction. Since 1945 there have been 11 business cycles with the average length of expansions at 58.4 months, and the average length of recessions at 11.1 months. History shows the question is not if the economic tide will turn but when it will turn.

Yield curve: a reliable

predictor of recessions

Recently, concern has been expressed over the so-called yield curve, which is an economic indicator that has consistently predicted turning points in the economy; it’s a reliable indicator of when expansions end and recessions begin. Typically, the yield curve is based on interest rates the U.S. government pays on its debt. Some of that debt is considered short-term debt, and some is considered long-term debt. The difference/spread between the interest rates on the government’s short-term debt and long-term debt is known as the yield curve. Long-term rates are usually higher than short-term rates because long-term investments are riskier than short-term investments. As an investor, you would want to earn more money on a long-term investment to compensate you for greater risks such as the risks of inflation rising and of default. The reason for the recent concern is the spread between short-term interest rates and long-term interest rates has been narrowing. Short-term rates have been rising faster than long-term rates, and in the past, when short-term rates have overtaken long-term rates, a recession follows.

According to Michael D. Bauer and Thomas M. Mertens, research advisors of the Federal Reserve Bank of San Francisco, “…the difference between long-term and short-term interest rates — is a strikingly accurate predictor of future economic activity. Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve.” To cut through the jargon, the terms negative term spread and inverted yield curve simply refer to times when short-term interest rates are higher than long-term interest rates.

The chart in this article shows a significant narrowing in the spread between long-term rates and short-term rates has occurred over the last four years. That spread is likely to continue narrowing as the Federal Reserve continues to raise short-term interest rates to prevent the economy from overheating and igniting inflation. Since December 2015, the Federal Reserve has increased short-term interest rates seven times, and after their last meeting on June 13, the Federal Reserve’s Federal Open Market Committee released the following statement, “The Committee expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.” Again, that jargon simply means the Federal Reserve expects to continue raising short-term interest rates, and with additional increases in short-term interest rates, the yield curve could invert. Of course, predicting exactly when the next recession will start is all but impossible. Still, Bauer and Mertens also noted, “a negative term spread was always followed by an economic slowdown and, except for one time, by a recession. The delay between the term spread turning negative and the beginning of a recession has ranged between 6 and 24 months.” The table in this article shows those delays for the previous five recessions.

Inevitably, our current economic expansion will end, and another recession will begin. When that recession begins is impossible to predict with any accuracy, but our next recession now appears to be on the horizon rather than beyond the horizon.