Another infallible economic indicator bites the dust: inverted yield curve edition

 

 - by New Deal democrat

No big economic data today. So let’s take a look at a significant forecasting tool. Some leading indicators are very good. But none is infallible. And the last few years have slain one of the most-touted for infallibility: the inverted yield curve.

For those who need a brief refresher, typically the longer the term of a bond, the more interest an investor will require for taking the risk of lending their money to the borrower for a longer period of time. Thus we typically expect a 30 year Treasury to yield more than a 10 year, and both to yield more than a 5 year, all three to yield more than a 2 year, and all of the above to yield more than a 3 month Treasury bill. That is called a normal, or regularized, yield curve.

But sometimes - typically but not necessarily always when the Fed is raising interest rates - the yield curve behaves abnormally, with some shorter duration Treasuries like the 3 month or 2 year durations paying more interest that longer duration Treasuries like the 10 year. That is called an inverted yield curve.

And for the past 50 years, it has been thought that an inverted yield curve means recession ahead.

Until now.

First, let me show you the historical record of the two most common measures of the yield curve: the 10 year minus 2 year treasury yield (blue) and the 10 year minus 3 month yield (red) since 1980:

The former measure doesn’t go back further, but the 10 year minus 3 month can be charted all the way back to the early 1960s:

So let’s summarize what we see. With the exception of the COVID lockdowns, which may never have been a recession otherwise, before every recession in the past 60 years, both measures of the yield curve above had inverted. About half the time, the 10 year minus 2 year had also re-normalized before the onset of the recession. And so in most cases had the 10 year minus 3 month comparison.

Astute observers will note that on one historical occasion there was a failure: during the 1966 “guns & butter” economy of LBJ, there was an inversion but no recession for another 3.5 years.

And, as I will document below, there has been a failure in this decade as well. 

The 10 year minus 2 year metric has almost always inverted first. The shortest period of time between inversion and recession has been 10 months (1980) while the longest has been 19 months (1990). The median period has been 15 months.

But the 10 year minus 2 year spread inverted in July 2022, a full 50 months ago (and counting). That’s almost triple the amount of time between the longest previous period of inversion to recession.

Similarly, going back to the 1960s, the shortest period of time between inversion of the 10 year minus 3 month spread has been 8months (2001) while the longest has been 25 months (1980). The median period has been 13 months.

But this decade the 10 year minus 3 month spread inverted in November 2022, 38 months ago, 1.5* more than even the longest such time in the past 50 years.

But, some have said, the real danger point is after the spread has re-normalized, pointing to all of the past times when a recession has begun after that normalization.

To begin with, about half the time no such re-normalization has occurred. So this metric appears to be random noise. But further, it relies upon an unstated assumption that the yield curve inversion is infallible. In other words, once there is an inversion, the recession will come either before or after a re-normalization, but it *must* come.

Well, certainly there is always another recession in the future *sometime,* but let’s see how this metric pans out as well.

The 10 year minus 2 year spread only un-inverted 3 times before recessions: by 2 months in 2001, 4 months in 2007, and 9 months in 1990. But this decade it un-inverted in August 2024, 25 months ago - almost 3* the maximum previous length of time.

And the 10 year minus 3 month spread un-inverted 7 previous times, with a duration of 1 month before at the least (2001) and 6 months before at the most (1990 and 2007). But this time around, measured monthly, it un-inverted in December 2024, 21 months ago, more than 3* the maximum previous duration. Even measured weekly it has been un-inverted for almost 12 months.

Only if we include the 1966 inversions and date them in comparison with the 1970 recession can we find any analogy, for the 10 year minus 3 month spread could be said to invert 42 months before the recession, and un-invert 25 months before. At present we are already past the former period, and only 4 months away from the latter. I submit that a “leading indicator” that takes almost half a decade to come to fruition is not an indicator at all.

So, if the inverted yield curve is busted as an infallible indicator, do I still plan to track it? Yes, because its past record is still good, and I use it only as part of a constellation of such indicators with good records that go back many years.

In which regard, let me give you the same graph, but over the past two years:

While the 10 year minus 3 month spread has continued to widen, the 10 year minus 2 year spread has narrowed again, most recently briefly to only 0.25%. Keep in mind from the above that the 10 year minus 2 year has almost always inverted first. And once it has narrowed to only 25 basis points, it typically has gone on in the near future to an inversion.

In other words, while the yield curve, like every other indicator, is not infallible, in a few months the clock might start ticking again.

 

Weekly Indicators for September 21 - 25 at Seeking Alpha

 

 - by New Deal democrat

My “Weekly Indicators” post is up at Seeking Alpha.

There are two big, and opposing, forces pulling the economy in opposite directions. On the one hand, there are the stagflationary effects of the oil price spike, and the secular sharp increase in bond yields. On the other, there is the Boom in AI related investment. Those two opposing forces are very much in evidence in most of the high frequency indicators.

As usual, clicking over and reading will bring you up to the virtual moment as to how these forces are showing up in the US economy, and bring me a penny or two in lunch money for my efforts.

Despite everything in Washington, manufacturing is Booming

 - by New Deal democrat

One of the things I occasionally pat myself on the back about is spotting new trends first. Such was the case one year ago, in the midst of the “mini-recession,” noticing that the regional Feds’ manufacturing indexes, which had languished for several years, were turning positive. Thus began the theme of an AI data center construction driven manufacturing rebound.

This year that trend has continued and even intensified. Which brings us to this morning’s report on durable goods orders for August.

The headline number for new durable goods orders by manufacturers (blue) was unchanged, but the much less noisy core capital goods number (red) increased a sharp 1.6%. The latter made a new all time high, as did the three month average (which takes out most of the noise) of the former. In the graph below, both are normed to 100 as of their pre-pandemic expansion highs in 2018:

And that’s not all. On a YoY% basis, new orders increased 8.5%, while core capital goods orders were up 14.1%. The below graph subtracts those values to show the current YoY gains at the “0” line:

The current Boom in the growth of manufacturing orders is equivalent to all of the best times in the last 30+ years except for the brief white-hot immediate post-pandemic Boom.

Finally, let’s compare that with industrial production in the manufacturing sector (orange), which did decline slightly in August; but the sharply increasing trend is similar:

One of the things I have learned over the past 20+ years that I have been doing this is just how hard it is to derail the U.S. economy. When several sectors point to a sharp downturn, most often another sector comes sneaking out of the shadows to power an upturn. And so, despite the incompetence and malignancy of the current Administration, so far the economy as a whole is refusing to buckle, despite important things like real incomes for most ordinary Americans turning down.

August new home sales consistent with a housing recovery. Unfortunately . . .

 

 - by New Deal democrat

In the past few months, I have described the housing market as being in a subpar equilibrium, with sales, construction, prices, and finally inventory moving more or less sideways - but simply not at an affordable level. This month I think I need to amends that, because unlike existing homes, new home prices probably *have* declined to an affordable level.

Let me start by repeating that new home sales are perhaps the most leading of all the housing sector metrics. But they suffer from being very volatile and heavily revised. So their three month moving average is more reliable as a signal.

With that said, this morning’s new home sales report for August was yet more evidence for both of the above theses. Sales, prices, and inventory all generally stayed on their recent trend level.

Sales (blue)increased 41,000 annualized to 684,000. This was the highest single month for sales this’d year. More importantly, the three month moving average was also at its highest level this year:

Further, a bottoming in inventory (red) is something we typically see towards or even after the end of a recession. And inventory, after bottoming at the end of last year has trended sideways to slightly higher this year. Were it not for the sharp upwards trend in interest rates, this would signify a recovering housing market. Keep in minds that these sales were for August, before the latest upward push in rates, so it is likely this trend meets its untimely demise in the next month or two.

Prices also continued their sideways to slightly declining trend, increasing $1,500, or 0.4%, for the month. But since they are not seasonally adjusted, the YoY% change ids most important - and it is obvious from the graph below that, July excepted, prices are at their lowest level in nearly five years:

Although I won’t bother with the graph, the YoY% price decline was -5.8%.

Where I am revising my opinion is in terms of affordability. The below graph deflates the median price of a new home by average weekly earnings, normed to 1 as of August:

Deflated by wages, the price of a new home is at its lowest level except for one month during the COVID lockdowns in almost 15 years! Were it not for 7%+ mortgage rates, the outlook for housing would be very positive. Unfortunately . . . 

In summation, housing - and in particular new home sales - is not currently forecasting a recession. Last month I closed with “With sales relatively stable and prices slowly deflating, the new home market is meeting the existing home market in a equilibrium, which is likely to remain unless something significant happens upstream, like an increase in mortgage rates back to 7%, possibly driven by a Fed rate hike.” Both of those “significant things” have since happened. 

We live in interesting times.

Extremely low jobless claims forecast unemployment rate declining below 4%

 

 - by New Deal democrat

Let’s take our regular weekly look at jobless claims. As a reminder, I look at these because they are an excellent short leading indicator for the economy.

Last week new jobless claims declined -1,000 to 197,000, continuing its streak of number close to all time historical lows. Thew four week moving average declined -1,750 to 202,250. With the typical one week delay, continuing claims rose 2,000 to 1.719 million:

Note that initial claims in particular are close to their previous all-time post-pandemic lows set in 2022.

On the YoY% basis more important for forecasting purposes, initial claims were down -10.0%, the four week moving average down -14.6%, and continuing claims down -10.3%:

All of these are extremely positive for the economy - indeed the most positive in thew past three+ years.

Lastly, the last time initial and continuing claims were at these levels, the unemployment rate was at 3.7%-3.9%:

In other words, this forecasts that the unemployment rate will continue to decline in the next several months not just to 4.0%, but likely even lower. We’ll find out a week from tomorrow.

The rebound in manufacturing employment is likely real, if fragile

 

 - by New Deal democrat

Over at Econbrowser, Prof. Menzie Chinn asks whether the gains in manufacturing employment as measured by the monthly payrolls report might be illusory, based mainly on a sharp deceleration in the ADP employment reports during July and August. While the current Administration in Washington is doing just about everything it can to sew chaos and throw monkey wrenches into the economy, I think the manufacturing employment recovery is real, if most likely narrowly based on AI-related spending.

Let’s start with Prof. Chinn’s contrast between the monthly ADP report (dark blue) and the payrolls report for manufacturing (red, right scale), together with ADP’s weekly data (light blue):

There certainly has between a stark contrast this year. Prof. Chinn also shows the QCEW comparison through March, which is also significantly weaker than the payrolls numbers, and will be used to revise them next February.

If the payrolls report were the only contrast, I would be inclined to be more concerned. But let’s take a look at some other manufacturing data from other sources.

First of all, both manufacturing production (red) and core capital goods orders (blue) for firms have been on a sustained upturn this year. And goods-producing employment as measured by the NY and Philly regional Feds (gold, right scale) has also picked up since spring:

Additionally, here is a comparison of the ADP figure with the monthly ISM manufacturing subindex for employment:

So we have four other sources - the Fed, several regional branches, the Census Bureau, and ISM - all showing an upturn in manufacturing employment this year, or preconditions for such an upturn, all independently. That suggests to me that it is the summer downdraft in the ADSP numbers that is anomalous.

For what it’s worth, the increase in manufacturing payrolls internally has followed an increase in the average weekly hours for manufacturing personnel, a long-time leading indicator, which started turning up early in 2025:

Again, I suspect this is a by-product of the $Trillions sloshing around in AI related building, so it rests on a fragile basis. But nevertheless it is a real underpinning for the recent employment growth.