The economic recovery is chugging along almost as fast as ever, but, beneath the surface, the best recession predictor we have is starting to flash yellow.
That indicator is the difference between interest rates on 10-year Treasury bonds and two-year ones. Now, the reason it tells us so much is that long-term rates show us what markets think short-term ones will average over that time, plus a little extra to make up for the risk that inflation ends up being higher than expected. So when long-term rates are lower than short-term ones — what's known as an inverted yield curve — it means that investors think short-term rates will be lower in the future than they are today. And why would that be? The only reason is if the Federal Reserve is going to have to cut them to fight a recession.
The good news, then, is that the yield curve isn't inverted yet, but the bad news is that it might not be long until it is. Indeed, the gap between 10-year Treasury yields and two-year ones fell to its lowest level since September 2007, when it got down to as little as 0.41 percentage points during trading last Tuesday. It has since widened back a bit to 0.488 points, but the point still remains: The bond market is signaling that the economic cycle may not be far from turning.
Goodbye, slow and steady recovery, and hello, the only thing worse than that.
This is really about one thing, and one thing only: Markets still don't believe the economy can grow that fast. Which is to say that President Trump's adherence to the standard Republican script of tax cuts and deregulation hasn't made things any better. The economy is still stuck in the same 2 percent to 2.5 percent growth it has been in for 10 years now for the same reason that the baby boomers are still retiring.
Who could have known, except everyone?
The important thing to understand here is that a slow-growing economy doesn't need high rates to keep inflation in check, and can get derailed even by low rates. The first part of that is why 10-year yields are still so low by historical standards, and the second is why two-year yields that are historically low themselves still aren't far away from being a problem for the economy. Another couple of rate hikes, which would send two-year borrowing costs up with them, might be all it would take for the whole curve to invert. Although the real danger is that the Fed might talk itself into the idea that this wasn't that big a deal. It is true, after all, that long-term rates are perhaps even lower than they “should” be right now because of all the unconventional policies the Fed used in the past. It's therefore not a stretch to imagine them telling themselves that this wouldn't be as concerning as it would normally be. The problem with that, though, is that it's also true that what seem like rather innocuous interest rate increases can be a big problem when the recovery is still so fragile that rates aren't much above zero. Just ask Japan. It has been stuck there for two decades now.
The point is that markets are telling the Fed it doesn't need to raise rates that much more to finish off the recovery, but it will finish off the recovery if it does much more than that.
Just in time for the 2020 election, too.