Recession Fears: What’s on the Horizon

Microsoft and Amazon are two of a handful of tech companies that recently laid off a significant number of employees. These actions, along with other indicators, have fanned the flames on recession fears. Use this guide to familiarize yourself with some of these key indicators and what they may mean for the future. 

Keeping an eye on the yield curve inversion

Long-term bonds generally provide higher yields than short-term bonds because investors demand higher returns to compensate for the risk of lending money over a longer period. Occasionally, however, this relationship flips, and investors are willing to accept lower yields in return for the relative safety of longer-term bonds. This is called a yield curve inversion. 

A yield curve could apply to any bonds that carry similar risk, but the most studied curve is for U.S. Treasury securities, and the most common focal point is the relationship between the two-year and 10-year Treasury notes. 
The two-year yield has been higher than the 10-year yield since July 2022, and beginning in late November, the difference has been at levels not seen since 1981. Other short-term Treasuries have also offered higher yields; the highest yields in early 2023 were for the six-month and one-year Treasury bills.¹  

• Note: Although Treasuries are often referred to as bonds, maturities up to one year are bills, while maturities of two to 10 years are notes. Only 20- and 30-year Treasuries are officially called bonds.

Predicting recessions 

Weakness or inflation control? 

Yield curve inversions do not cause a recession; rather they indicate a shift in investor sentiment that may reflect underlying economic weakness. A normal yield curve suggests that investors believe the economy will continue to grow, and that interest rates are likely to rise with the growth.

An inversion suggests investors see economic challenges that are likely to push interest rates down and would rather invest in longer-term bonds at today's yields. This increases demand for long-term bonds, driving prices up and yields down. 

The current situation is not so simple. The Federal Reserve has rapidly raised the benchmark federal funds rate to combat inflation, increasing it from near 0% in March 2022 to 4.25%–4.50% in December. The funds rate directly affects other short-term rates, which is why yields on short-term Treasuries have increased so rapidly. The fact that 10-year Treasuries have lagged the increase in the funds rate may mean that investors believe a recession is coming. But it could also reflect confidence that the Fed is winning the battle against inflation and will lower rates over the next few years. This is in line with the Fed's projections, which see the funds rate peaking at 5.0%–5.25% by the end of 2023, and then dropping to 4.0%–4.25% in 2024 and 3.0%–3.25% in 2025.⁵

Inflation slowed somewhat in October and November, but there is a long way to go to reach the Fed's target of 2% inflation for a healthy economy.⁶ The fundamental question remains the same as it has been since the Fed launched its aggressive rate increases: Will it require a recession to control inflation or can it be controlled without shifting the economy into reverse?

Other indicators and forecasts

The yield curve is one of many indicators that economists consider when making economic projections. Among the most closely watched are the 10 leading economic indicators published by the Conference Board, with data on employment, interest rates, manufacturing, stock prices, housing, and consumer sentiment. The Leading Economic Index, which includes all 10 indicators, fell for nine consecutive months through November 2022, and Conference Board economists predict a recession beginning around the end of 2022 and lasting until mid-2023.⁷ Recessions are not officially declared by the National Bureau of Economic Research until they are underway, and the Conference Board view would suggest the U.S. may already be in a recession.

In The Wall Street Journal's October 2022 Economic Forecasting Survey, a majority of economists believed the U.S. would enter a recession within the next 12 months, with an average expectation of a relatively mild 8-month downturn.8 More recent surveys of economists for the Securities Industry and Financial Markets Association and Wolters Kluwer Blue Chip Economic Indicators also found a consensus for a mild recession in 2023.^9–10

For now, the economy appears fairly strong despite high inflation, with a low November unemployment rate of 3.7% and an estimated 3.8% Q4 growth rate for real gross domestic product.11–12 Unfortunately, the indicators and surveys discussed above suggest an economic downturn in the next year or so. This would likely cause some job losses and other temporary financial hardship, but a brief recession may be the necessary price to tame inflation and put the U.S. economy on a more stable track for future growth.

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