Moneybeat - Recession warning signs

MARY REICHARD:  Next up on The World and Everything in It … the Monday Moneybeat.

NICK EICHER:  Time now for our regular conversation on business, markets, and the economy. Financial analyst and adviser David Bahnsen is here … Morning, David.

DAVID BAHNSEN:  Good morning, Nick. Good to be with you.

NICK EICHER:  All right, the moment I saw this story cross the wire … I couldn’t wait to talk to you for an intelligent explanation … and you know what story I’m referring to … this phenomenon in the market for Treasury bonds … a yield-curve inversion in that market … in this case, that the yield on a two-year Treasury is higher than the yield demanded for a ten-year Treasury note.

Now, if you read the financial press … and this broke into the regular press, too … you saw headlines like these: “Yield-curve inversion could signal a recession” … “Recession warning sign flashes as yield curve inverts” … and here’s one I like best: “The ‘Yield Curve Inversion’ Is Signaling Something Important. No One Can Agree on What It Is.” But it does go on to say that the inversion is a predictor of coming recessions on some kind of time horizon. What can you tell us about this?

DAVID BAHNSEN:  Yeah, well, let's first of all start with that line you just used about on some kind of time horizon, it isn't particularly helpful, that the yield curve can sometimes be a predicate to a recession, when the historical reality is that the timeline can be two years later, six months later, any number of different things? The question is causation versus correlation. And then the question is false positives, because we have not had a recession every time the yield curve is inverted. But we have generally had a yield curve inversion, before there have been recessions. So that is a very important distinction. The number one thing I've studied historically on this or learned from my historical studies, is that the length of inversion matters. If the yield curve inverts for a few weeks, it often is more aligned with a false positive. And if the yield curve is inverted for a longer period of time, it is more frequently meant a recession came at some point down the line. But I don't believe that this is causative. It is indicative of something malfunctioning in the economy; it is not causing something malfunctioning in the economy. But from a realistic standpoint, what are the amount of recessions we've had in history at 3.6% unemployment? When one talks about a recession, you generally have unemployment going higher, not lower. And you generally have people trying to get jobs, not jobs, trying to get people. Now what the recession camp would say is, “Yeah, but these things are indicative that that's going to change, that unemployment will go higher, and that demand will drop.” And they'll point to like a consumer confidence number going down or something. But I think those are pretty unconvincing metrics. So there is plenty of reason, fundamentally, to not believe a recession is coming. But that's because of other economic problems: labor shortages, supply side disruptions, price escalations. I think that everybody loves a big sensationalistic story, but in this case, there's just certain counterfactuals that make it inconvenient to draw a clean narrative.

NICK EICHER:  But maybe explain why a yield-curve inversion is indicative of something amiss in the economy … what we’re talking about is the return on a U.S. Treasury is more for a short-term Treasury than it is on a longer-term note … a two-year versus a ten-year … when you’d expect a ten-year investment to yield more than a two-year one.

DAVID BAHNSEN:  I want to reword a couple of these things because I get what you're saying, but I don't think it's precise. It does amount to a return for investor in the end, but the point of it is, it's about the borrower. The lender is only requiring the borrower - in this case, the lender is someone like you or me and the federal government is the borrower - but the lender is requiring the borrower to pay them back the same in interest for 10 years of borrowing as they would for two years of borrowing. Where generally a healthy yield curve implies that there would be more money required for a greater time commitment for the simple reason that time has a value. The time value of money suggests you want a greater amount of interest to compensate you for the greater risk you're taking, the greater uncertainty and so forth. Now, there are two ways the yield curve can invert. It could be because the short end comes higher. It could be because the long end comes lower, or it could be both. In this case, it's entirely about the short end of the curve - the two year going way higher. If the 10 year were to go higher, that would uninvite the yield curve, and it would imply that there has indeed been some increase in expectation of growth. For all the inflation talk, the 10 year right now is still a 2.3%. So we continue to have short-term price pressures that everyone knows about, and no expectation in the bond market, that those are going to persist. And unfortunately, we don't have much expectation in the bond market have great long-term growth either. And that's been a problem since the financial crisis. So the yield curve tells a number, a number of different stories, not just one. And ultimately, the problem we're dealing with right now is low long-term growth expectations. And yes, in the meantime, you're getting normalization at the front end of the curve, the two year should be at 2%, two and a half percent. The problem is that the 10 year is only at the same. So to get a healthy yield curve. You want longer term growth expectations to go up.

NICK EICHER:  All right, David Bahnsen … financial analyst and advisor … head of the financial planning firm The Bahnsen Group

You can catch David’s daily writing at Dividend Cafe-dot-com … sign up there for his daily email newsletter on markets and the economy … David, thanks again!

DAVID BAHNSEN: Thanks so much, Nick.

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