Inverted Yield Curve Not A Sufficient Condition For Recession-Credit Growth & Rate Levels Matter Too
|in:Viewpoints
The inverted Treasury yield curve has raised concern over the risk of recession in 2023, and for a good reason. An inverted yield curve has occurred before the past eight recessions. Yet, something is awry. Banks are not restricting credit as they typically would with an inverted yield curve, and businesses and consumers are borrowing at banks at the fastest rate in fifteen years. What's up?
The thinking behind the inverted yield curve is that banks slow and eventually stop lending when bank funding costs exceed what banks can earn by lending. Yet, bank credit has been accelerating throughout 2022. The latest data for November shows bank lending to businesses, real estate, and consumers rising 11.8% over the comparable period one year earlier. That's the fastest annual growth since 2007.
Why are banks lending so much with an inverted yield curve? Banks' total costs of funds are not determined solely by the rate of federal funds. Customer deposits account for half of the funding costs for many big banks. And with customer deposit earning (or costing) less than 70 basis points, the bank's all-in funding costs remain relatively low. So it's still profitable to lend nowadays.
That raises questions about the recessionary signal from an inverted yield curve because, in previous periods of inverted yield curves, bank lending slowed sharply, often contracting (see chart). Can the inverted yield curve signal be trusted if bank credit is accelerating, not slowing, or contracting as in previous periods? I would think not.
Also, why are businesses and consumers still borrowing briskly after the Fed substantially raised official rates? Because the federal funds rate is not crushingly high, at least not yet. In the past, the federal funds rate proved restrictive when its level equaled or exceeded the growth in gross income and output (see chart). In other words, to slow domestic demand, the Fed had to raise rates equal to or above the increase in gross income and output.
At the end of the third quarter of 2022, the growth in GDP exceeded the Fed funds rate by almost 600 basis points. That's huge, indicating the economy is far from one of the conditions in place before prior recessions. Even if the Fed median forecasts of higher official rates and markedly slower nominal growth are on the mark, the GDP-Fed funds' gap will not be closed before mid-year 2023. A recession beginning around mid-year runs counter to the bullish forecasts of a strong half for 2023.
Many believe an inversion in the market yield curve, or the spread between the yield on three-month Treasury bills and the 10-year treasury, is a robust forecasting tool due to its consistent and reliable track record. Yet, yield curve inversion, by itself, is not a sufficient condition for an economic recession. Slowing or contracting credit growth and official rate levels equal to or exceeding income growth are also necessary conditions. Those conditions are not present, so until they are, the yield-curve recession signal will remain a forecast, not a reality.
Joseph G. Carson
AuthorMore in Author Profile »Joseph G. Carson, Former Director of Global Economic Research, Alliance Bernstein. Joseph G. Carson joined Alliance Bernstein in 2001. He oversaw the Economic Analysis team for Alliance Bernstein Fixed Income and has primary responsibility for the economic and interest-rate analysis of the US. Previously, Carson was chief economist of the Americas for UBS Warburg, where he was primarily responsible for forecasting the US economy and interest rates. From 1996 to 1999, he was chief US economist at Deutsche Bank. While there, Carson was named to the Institutional Investor All-Star Team for Fixed Income and ranked as one of Best Analysts and Economists by The Global Investor Fixed Income Survey. He began his professional career in 1977 as a staff economist for the chief economist’s office in the US Department of Commerce, where he was designated the department’s representative at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. In 1979, Carson joined General Motors as an analyst. He held a variety of roles at GM, including chief forecaster for North America and chief analyst in charge of production recommendations for the Truck Group. From 1981 to 1986, Carson served as vice president and senior economist for the Capital Markets Economics Group at Merrill Lynch. In 1986, he joined Chemical Bank; he later became its chief economist. From 1992 to 1996, Carson served as chief economist at Dean Witter, where he sat on the investment-policy and stock-selection committees. He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Honorary Doctorate Degree, Business Administration Youngstown State University 2016. Location: New York.