The yield curve was upside down. Stocks fell. Recession worry filled the headlines.
After the 10-year Treasury yield fell below the two-year Treasury yield in August, stocks declined, and financial media outlets called attention to an imminent recession. Yet, despite the yield curve inverting before every recession since the mid-1950s, the alarm surrounding the latest yield curve inversion is overstated according to Bender Commercial Principal, Michael Bender.
“In order to explain why this particular yield curve inversion shouldn’t cause recession alarm you have to look at the strength of the U.S. economy,” said Michael Bender. “Looking at all the factors, not just the yield curve, gives us a better picture of an upcoming recession or lack thereof.”
By most definitions, a recession is two consecutive quarters of negative GDP growth. According to the U.S. Bureau of Economic Analysis, the U.S. saw 2.0% growth in real gross domestic product in the second quarter of 2019 and the economy is forecasted to stay near 2.0% growth in the second half of the year according to Kiplinger.
That GDP growth is fueled by four components: consumption, government spending, net exports, and business investment.
Accounting for 68% of 2018’s GDP, the biggest component to GDP is consumer spending. According to The Wall Street Journal, through July, retail sales have increased this year, consumer confidence has rebounded, and productivity—output per hour worked—has experienced some of the largest increases in decades.
On top of those strong indicators, there are more job openings than unemployed people in the U.S. at the start of September. Fueled by the strength of the labor-market, consumer spending is primed to increase, not decrease.
Locally, Sioux Falls is in lockstep with national consumer spending. “Sales tax receipts for the City have been solid and trending upward over the last twelve months,” said the City of Sioux Falls’ Director of Finance, Shawn Pritchett.
According to the city’s monthly financial reports, Sioux Falls’ sales tax growth rate has been 4.5% between July 2018 and July 2019. Pritchett concluded, “August 2019 numbers haven’t been posted yet, but the month was particularly strong from a sales tax perspective.”
Government Spending and Net Exports
In 2018, government spending accounted for 18% of GDP, and with growing deficits through the first half of the year government spending increased 3% in 2019. Net exports, on the other hand, decreased last year’s GDP by 3.3% and have remained close to that number in 2019, down 3.1%.
The last category, business investment, represented 18% of 2018’s GDP. In the second quarter of this year business investment shrunk 0.6% amid concerns about the looming trade war with China and how it might impact supply chains and costs.
“Sioux Falls feels the impacts of a trade war as strongly as anywhere else in the country due to our connection to the ag economy,” said Bender. “We have strong healthcare and finance drivers, but the tie to agriculture remains at the heart of our economy. Trump continues to extend the 25% tariff hike, but should the other shoe drop we’ll feel that pain in the ag market locally and it could affect GDP nationally.”
Looming Recession or Incomplete Picture?
After looking at each component of GDP the U.S. economy looks strong at the moment, so why did the yield curve invert?
“We’ve seen some strange activity in the Treasury market in the last ten years, really since the Great Recession,” said Bender. “The Fed’s flooded the long-term asset side through quantitative easing, and that’s depressed the 10-year Treasury yield.”
According to The Wall Street Journal, Fed researchers estimate that quantitative easing may be pushing down the 10-year Treasury yield by as much as 0.7 percentage point in 2019.
Bender added another factor, “On top of that, we’ve seen foreign investors moving into U.S. bonds more than you would have otherwise because the low-yield U.S. bonds are safer than the negative yield bonds we’re seeing worldwide.”
Worldwide there are over $16 trillion in government bonds with negative yields. This movement into U.S. bonds pushes their prices higher and is another factor depressing longer-term Treasury yields.
Thirdly, the government spending mentioned above was funded in large part by issuing short-term Treasury bills. This action created upward pressure on the short end of the yield curve.
“The combination of quantitative easing and foreign investment creating downward pressure on the 10-year Treasury yield and the influx of short-term Treasury bills creating upward pressure on the 2-year Treasury yield results in the yield curve inverting,” Bender said. “But after looking at the big picture I don’t see a substantial weakness in the economy.”
We may see a recession in coming years, but the latest inverted yield curve should not be the cause for alarm as it has been in the past.
- Many financial outlets reported recession worries after the yield curve inverted in August. There are reasons to believe the common recession signifier may be flawed in this instance.
- The U.S. economy remains strong after looking at the four components of GDP: consumption, government spending, net exports, and business investment.
- The Sioux Falls economy reflects national GDP trends, but could be affected by a change in agriculture markets due to trade wars.
- There were extraneous factors creating upward pressure on short-term Treasury yields and downward pressure on long-term Treasury yields that contributed to the yield curve inversion including quantitative easing, foreign investment, and the issue of Treasury bills.