Why Recession Predictions Have Been Wrong So Far

Why the shift? Regardless of whether we eventually end up in a recession, the key here is how an inverted yield curve may not mean the same as it did 20 years ago. Has our economy become far more resilient in the face of restrictive interest rate policies? 

Let’s look at what history shows us. Back in the 1950s, ’60s and ’70s, manufacturing was the engine of the U.S. economy, with the purchase of durable goods often facilitated by credit. If one wanted to buy a house, a 30-year fixed-rate mortgage was the only choice. Moreover, that choice was typically provided by a savings and loan institution that borrowed short-term from savers and lent long-term for houses or medium-term for cars.

Taking interest-rate risk and surviving short periods of inverted yield curves was the savings and loan business model, since efficient rate hedging vehicles were not available. When the Fed hiked interest rates, lending slowed for houses and cars, the economy slumped, and unemployment eventually started to rise.

Fast forward to today. The U.S. is a service-sector economy, and most service purchases do not involve a loan or credit. Mortgages come in all shapes, sizes, terms and maturities, and are originated by specialized brokers that package and sell the mortgages to investors who want to hold this risk. For financial institutions, the ability to hedge and manage interest-rate risk is further supported by deep markets in swaps, futures and options. 

Higher rates, which alter the time value of money, still have a profound impact on asset markets, from equities to fixed income. But the impact of those rates on the real economy is much less clear as the U.S. economy evolves. Yet, most econometric models still rely on historic relationships, which don’t take into account recent structural changes impacting interest-rate sensitivity.

Moreover, the last three serious recessions all required something big and systematic to break. In 1991, it was the savings and loan industry and the housing market, brought on by tighter credit conditions. In 2008, it was the financial crisis brought on by risk taking in subprime housing. In 2020, it was the Covid-19 pandemic, which had nothing to do with rates.   

This year, the failure of a few niche regional banks could have been the trigger for contagion and a serious banking system collapse. That was not the case because regulators quickly backstopped the system. Additionally, most banks had hedged their positions. 

Could it be that a less interest-rate sensitive economy and a regulatory network committed to preventing systemic financial-system breakdowns has reduced the power of an inverted yield curve to forecast a recession? Time will tell. Until then, investors should be cautious about relying on historical parallels as they prepare their portfolios for the risks ahead.