A growing rash of economists are warning the odds of a recession have increased amid a historic inversion of the yield curve—a telltale sign of a looming economic slowdown after the Federal Reserve on Wednesday raised rates to the highest level since the Great Recession and signaled its policy would be more aggressive than previously anticipated.
Yields on the 10-year Treasury surged more than 10 basis points to nab a new 11 year-high of 3.829% on Friday, while the 2-year Treasury hit a 15-year record of 4.266%—deepening the yield curve inversion to some 50 basis points, the widest gap in more than 30 years.
Since July the yield curve has been inverted—when short-term yields fall below longer-term returns—in a sign investors are more bearish about the economy’s long-term prospects, and the inversion only deepened after the Fed on Wednesday raised rates by 75 basis points and suggested it may institute another unusually large hike again in November.
In a note to clients, analyst Tom Essaye of the Sevens Report explained the steepening inversion “makes sense” because a more aggressive Fed, and higher rates that make borrowing more expensive, will temper demand and stunt economic growth in hopes of reducing inflation, but he also warned the magnitude of the inversion has become “very concerning.”
A Federal Reserve study in 2018 found every recession in the past 60 years has been preceded by a yield curve inversion, and Essaye says the widening gap between 2-year and 10-year Treasurys is “screaming that a serious economic contraction is coming,” adding “everyone should be preparing” for a material economic slowdown in the coming months and quarters.
In a Friday note, Bank of America economists said they expect the economy will fall into a recession in the first half of next year, with real GDP falling 1% after adding 5% last year, and unemployment rising to 5.6%—potentially wiping out more than a year of job gains.
Fed officials doubled down on their most aggressive economic tightening campaign in three decades on Wednesday, raising interest rates by three-fourths of a percentage point for the third time in a row and pushing borrowing costs to 3.25%—the highest level since 2008. Though they had originally projected the federal funds rate would only climb to 3.4% this year, they now project it will climb to 4.4%, suggesting another 75 basis point hike could be on the table in October. “With this new alignment between the Fed and markets, the questions now are when and how bad the recession will hit,” says Mace McCain, the chief investment officer of Frost Investment Advisors.
Stocks plunged deeper into bear market territory after the Fed’s hawkish message, with major indexes eclipsing yearly lows on Friday. The S&P 500 is down 23% this year, and economists at Goldman project it will sink another 3% by December and could take more than a year to recover losses. The tech-heavy Nasdaq has plummeted 32% since January, the Dow nearly 20%. “Looking out over the next one to two months, we don’t have much conviction at all on equities,” says Adam Crisafulli, founder of Vital Knowledge Media. “Sentiment is palpably horrible.”
Existing home sales fell for the seventh straight month in August as rising interest rates continued to sideline potential home buyers, according to the National Association of Realtors. In a statement, the association’s chief economist Lawrence Yun called the housing sector “most sensitive to” the Fed’s interest rate hikes and said the softness in home sales reflects this year’s escalating mortgage rates, which hit a 15-year high of nearly 6.3% this week—driving up the cost of monthly payments on new mortgages by more than 55%, an average of hundreds of dollars each month.
Despite pockets of the economy already reeling from the Fed’s hawkish policy, the job market remains firmly strong, effectively justifying the aggressive action. Initial jobless claims were little changed this week and continued claims actually edged lower. However, many experts say it’s inevitable that the labor market will soon start to cool. “It’s possible that the unemployment rate could gently glide higher and wages cool without an outright recession—but it’s never happened before,” says Bill Adams, chief economist for Comerica Bank.
Though it slowed for a second-month straight, inflation clocked in at a worse-than-expected 8.3% in August—far worse than the Fed’s long-standing target of 2%. Bank of America economists project inflation won’t return to that level until the end of 2024.