As the economic landscape in the United States unfolds, speculations about a potential slowdown or recession in 2025 have gained momentum. The term ‘soft landing’ became a buzzword towards the end of 2023, with economists conjecturing about the US economy experiencing a soft landing in the coming years.
One factor contributing to the uncertainty is the inversion of the bond yield curve in the US, a concern that recently caught the attention of Canadian Economist Campbell Harvey. The inversion, historically an indicator of an impending recession, has accurately predicted downturns eight times since 1968, without any false signals. Harvey’s prediction, based on yields inverting in the fall of 2022, suggests a potential recession in the first or second quarter of 2025. However, is this projection inevitable?
Understanding bonds, yield, and the bond yield curve is essential to grasp the intricacies of this economic indicator. A bond, essentially a debt instrument issued by governments and corporations, involves a return for investors known as the bond yield. The bond yield curve, a traditional recession indicator, observes the relationship between short-term and long-term bond yields.
Since 1950, whenever the yield on long-term bonds falls below that of short-term bonds, an inversion occurs, historically preceding a recession. The current situation reflects an inversion since July 2022, with the yield on 10-year bonds lower than that on 2-year bonds.
The inversion raises concerns because it has consistently foreshadowed recessions in the US market over the past 70 years. Analysts suggest a potential recession or economic downturn in 2024.
However, the question arises: Does yield inversion guarantee a recession? While historical data shows a correlation, experts clarify that a recession doesn’t necessarily follow immediately after the inversion. Studies indicate a 12-14 month lag between yield inversion and the onset of a recessionary phase.
Economists stress that inversion alone doesn’t serve as the final verdict on a recession, as sometimes the curve de-inverts before a downturn begins.
A critical aspect contributing to the inversion is the significant increase in the yield on short-term bonds, linked to the US Federal Reserve’s short-term policy rate. The Fed, combating inflation, raised short-term interest rates from near zero in 2020 to 5.25-5.50 per cent currently. Analysts anticipate a potential rate cut in the future to safeguard the US economy from an economic downturn or recession.
Adding to the discourse, Bill Gross, co-founder and former chief investment officer of Pacific Investment Management, recently recommended the US Federal Reserve to cease winding down its balance sheet and consider reducing interest rates in the coming months to avoid a recession.
