Economic research and the collective financial market wisdom agree: An American business cycle downturn is inevitable over the next twelve months.            

Financial markets’ proposition is based on the yield curve analysis. Wall Street rainmakers get huge (six figure) salaries for producing a line that plots the yields (i.e., interest rates) of bonds of same credit quality (such as U.S. Treasury IOUs) but different maturities. And what you get there is the almighty U.S. Treasury yield curve.

The analytic part is equally simple, intuitive and apparently logical. People who lend money to the Treasury get lower interest rates on short-term (say, three-month) bonds, compared to longer term bonds maturing in two, five, ten or thirty years.

That, of course, makes sense – because you want to bring in that sneaky tax called inflation. In other words, you want to get a real (inflation adjusted) return on your investment.

Meet the Treasury’s inverted yield curve

As a result, bonds with longer maturities have an inflation component built in – depending on how much investors trust that a central bank will deliver on its mandate for price stability.

Here is an example.

At the close of Wall Street trading last Friday (August 18, 2023), the U.S. Treasury paid an interest rate of 5.43% to people buying its three-month bonds, but it paid 4.94% on its two-year bond, and it even got away with only 4.25% on its benchmark ten-year bond.

That’s an eye-popping Treasuries sale. And if you plot all that, with interest rates on the vertical axis and time on the horizontal axis, you get that proverbial U.S. Treasury’s yield curve.

Normally, you get a neat upward sloping curve. But, in this case, you will get a strange thing called an inverted yield curve, because the Treasury is paying more for three-month debt than for two- or even ten-year loans to finance Uncle Sam’s liabilities.

What went wrong here?

Investors told the Treasury – and the U.S. Federal Reserve (the Fed) – that the three-month bond will get cheaper (the higher the yield, the lower the price of the bond) because the policy interest rate will have to go further up to check inflation.

Conversely, longer term bond yields reflect investors’ view that, at some point, higher credit costs will stop and reverse inflation by causing economic recession. Policy interest rates will then be cut (and the price of bonds will go up) to salvage jobs and incomes.

As an aside, you can see that high and rising inflation shows always, and everywhere, a flagrant failure of monetary policy.

But back to the message of our currently inverted yield curve: U.S. financial markets are expecting an economic recession that will suppress inflation and raise bond prices by declining interest rates.

Should you believe all that? Well, the record shows that Treasury’s inverted yield curves have correctly anticipated every U.S. recession over the last 70 years. And those inversions have lasted between 10 and 20 months, with most of the recent recessions occurring in the lower end of that range.

Democrats’ comfort growth and inflation zones

The present Treasury's yield curve inversion is in its eighth month, which means that definite signs of a growth slowdown should be readily apparent by the end of this year. Wall Street is betting the house on it.

Economic research of business cycle dynamics is a bit different. It relies on the degree of monetary tightening and on the time lags in the effect of monetary policy. For example, given the fact that the policy interest rate has been raised from 0% to 5.33% since late January of 2022, one should begin to see a clear slowdown of U.S. GDP growth.

Evidence of that is still very tentative, if one takes a slight growth deceleration in the first half of this year compared with the second half of last year. The reason for that is (a) it takes between six months and two years to see the impact of credit tightening, and (b) U.S. interest rates must go much higher to depress excess demand in labor and product markets.

A simple rule of thumb has been derived to indicate the degree of monetary tightening needed to maintain neutral and restrictive policy positions. According to that rule, a policy neutrality is achieved and maintained with a real (inflation adjusted) policy interest rate of 2%.

Here is what that means now. Taking the core consumer price inflation rate of 4.7% for July and last Thursday’s (August 17) federal funds rate of 5.33%, we get a real policy rate of 0.63%, strongly indicating that the U.S. monetary policy is still quite expansionary. At the current reference inflation rate of 4.7%, the federal funds rate would have to be raised by 1.37% just to reach a policy neutral position.

The Fed is certainly familiar with that policy rule, as might be inferred from its latest statements that further interest rate hikes could be necessary to stop and reverse inflation toward 2%.

I, however, don’t believe that the Fed will raise the federal funds rate by an additional 2% or 3% in the runup to an election year. I suspect that Democrats are quite happy with an inflation rate of 4% or 5%, and a GDP growth in the range of 2% to 3%. The White House can do that by unleashing plentiful energy and food supplies to contain the general inflation. Quite possibly, the Democrats might also realize that holding off the confrontation with Russia and China would also help to keep the global supply chains in good order.