Are Australia and the US heading for severe recessions?

In “Dude, Where’s My Recession?” (The New York Times, 14 July) Paul Krugman noted: “almost a year has passed since the U.S. Bureau of Economic Analysis, which estimates gross domestic product, announced that real GDP had declined over the previous two quarters – a phenomenon that is widely, although incorrectly, described as the official definition of a recession.” Late last year, he added, the Federal Reserve’s Open Market Committee was “predicting an unemployment rate of 4.6% by late 2023; private forecasters were predicting 4.4%. Either of these forecasts ... implied at least a mild recession.”

Reviewing these and some other data, Krugman concludes: “I can’t think of another example in which there was such a universal consensus that recession was imminent, yet the predicted recession failed to arrive.” “To be fair,” he conceded, “we don’t know for sure that these predictions will be falsified. But ... the economy would have to fall off a steep cliff very soon to make them right, and there’s little hint in the data of that happening ... So it sure looks as if economists made a bad recession call.”

That’s possible. Equally, it’s sensible to investigate what Krugman’s overlooking and the possibility that he’s mistaken – or, at least, that his announcement of victory over recession, like George W. Bush’s declaration of “mission accomplished” in Iraq in 2003, is premature.

If Krugman’s wrong, it’d be hugely ironic: a few years ago, as he noted on 14 July, the International Monetary Fund analysed economists’ ability to foresee downturns – and in his words “basically found that they never succeed.” (Actually, that’s not what the IMF said. Its “main finding” was that, “while forecasters are generally aware that recession years will be different from other years, they miss the magnitude of the recession by a wide margin until the year is almost over.”) Economic forecasters don’t just foresee slumps which never eventuate: both private and official seers are also “equally good at missing recessions” which do arise (see “How Well Do Economists Forecast Recessions?” IMF Working Paper No. 2018/039, 5 March 2018).

A crucial question thus arises: is Krugman the most recent – and among the most prominent – in a long queue of economists who’ve repeatedly failed to see the recession unfolding right in front of their noses? Wouldn’t it be a hoot if a recession erupted just when the mainstream sounded the all-clear? With that possibility in mind, in this article I establish five key points:

1. America’s 10 year-three month yield curve has been inverted since last year – and is now more steeply inverted than at any time since 1980.
2. Australia’s 10 year-three month curve, too, has inverted.
3. This curve’s inversion has nearly always (in the U.S.) and typically (Australia) preceded a recession by ca. 6-12 months.
4. In both countries, the cause of the inversion strengthens the case for recession. The supply of money rarely contracts: but in it’s now shrinking at the fastest pace since 1974 (Australia) and since before 1960 (U.S.).
5. In both countries over the past half-century and more, the confluence of monetary contraction and yield curve inversion has invariably preceded recessions.

In light of these points (as well as in those I’ve posted since late last year), Leithner & Company remains well-positioned for a severe economic downturn and a consequent sharp fall of equity markets. More generally, since 1999 we’ve repeatedly erred on the side of bearishness – and thereby successfully minded the downside and let the upside mind itself.

Two Preliminaries

It’s vital to emphasise: my purpose is NOT to stoke anxieties; still less is it to induce anybody to panic, liquidate his portfolio and run for the hills. Instead, it’s to encourage you, calmly and rationally, to act sensibly in light of conflicting information (namely the weight of evidence for and against the likelihood of recession). To do so, you must ultimately think and act for yourself. Unfortunately, most people tamely accept the consensus, few actively consider reasoned alternatives – and very few, when necessary, are prepared to ignore and even defy the mainstream. 

Secondly and most importantly, although it’s rarely mentioned it’s nonetheless profoundly true: for many people, arguments and evidence about the odds of recession are beside the point. At least one-quarter of Americans, as I detailed in America’s permanent recession: Is it coming to Australia? 19 April 2022), have for years and even decades endured a state of semi-permanent recession. To them, the question isn’t “is a downturn coming?” Instead, it’s “will it ever leave?”

Although the percentage of Australia’s population in such strife likely isn’t as large, it’s surely growing. One in ten of this country’s households, The Australian reported on 27 July, is now “unable to pay a gas, water or electricity bill as the nation’s cost of living crisis worsens.” Should a severe recession eventuate, well-to-do investors will encounter mere inconvenience – but a significant and growing underclass will suffer even greater hardship. The rest of this article should be read with that sobering thought – which economists, journalists and politicians in both Australia and the U.S. discount or ignore – in mind.

What’s a Yield Curve?

A yield curve is a graph of the variation of comparable bonds’ yields (rates of interest) as a function of their maturity. If, for example, we plotted the maturities of U.S. Treasury securities (whose major maturities are one month, three months, one year, five years, 10 years, 20 years and 30 years) on an x (horizontal) axis, and their yields on a y (vertical) axis, we’d see that, since the Second World War, the trend of yields (“yield curve”) has normally sloped upwards. Typically, in other words, the longer is the Treasury’s maturity, the higher is its yield. 

Why? Since the Second World War, market participants have usually – and rightly – anticipated that the consumer price index will rise. If so, they’ll demand compensation; hence the generally higher yields of longer-term investments. Furthermore (or alternatively), the economy faces more risks and uncertainties over the distant future than in the near term. Hence the longer is a bond’s duration, the greater (in general) is the yield that investors demand as compensation for risks.

Conversely, an “inverted yield curve” occurs when this typical relationship reverses: in these infrequent intervals, short-dated bills’ yields exceed long-dated bonds’ yields.

Using data collected by the Federal Reserve Bank of St Louis, Figure 1 plots the “ten year-three month” yield curve at monthly intervals since January 1960. Normally, the yield of the longer-maturity (ten-year) security exceeds the yield of the short-maturity (three-month) security. Hence observations in Figure 1 are mostly greater than 0%. Occasionally, however, the curve flattens (meaning that the short-term yield equals, more or less, its long-term counterpart) and inverts (i.e., the yield of three-month T-bills exceeds the yield of ten-year bonds); the more severe the curve’s inversion, the greater the extent to which observations dip below the 0% threshold.

Figure 1: U.S. Treasury Ten-Year Bond Yield minus Three-Month Bill Yield, Monthly Observations, January 1960-June 2023

Since January 1960, the U.S. Treasury’s ten-year bond’s yield has averaged 5.83% and its three-month bill’s yield has averaged 4.36%; hence this yield curve has, on average, sloped upwards; moreover, the slope has averaged 5.83% - 4.36% = 1.47%. The curve sloped most steeply upwards (4.42%) in September 1982 and most steeply downwards (-2.65%) in December 1980.

In June 2023, the ten-year bond’s yield averaged 3.57% and the three-month bill’s yield averaged 5.14%; hence the curve was more inverted (3.57% - 5.14% = -1.57%) than at any time since 1980. Moreover, it’s been inverted since November of last year.

Why Does the 10 Year-Three Month Yield Curve’s Inversion Matter?

Why in general should a yield curve’s inversion – and why in particular should the 10 year-three month curve’s current inversion – concern investors? In general, this curve’s slope is one of the most powerful predictors of economic growth, consumer price inflation and economic growth. The curve inverts when investors expect CPI and rates to fall – and they typically expect these things when they anticipate a downturn.

In particular, since 1960 the inversion of the 10 year-three month yield curve has been a near-perfect leading indicator of recession.

That’s why its slope is a component of the Federal Reserve Bank of St Louis’ Financial Stress Index. It’s also why the Conference Board has incorporated a related curve (i.e., the difference between the 10-year Treasury’s rate and the federal funds rate) into its Index of Leading Economic Indicators. 

Table 1 lists (1) the 10 intervals since 1960 during which the 10 year-three month yield curve has inverted, and (2) the nine recessions since 1960 as determined by the National Bureau of Economic Research (NBER, for details, see Recessions usually crush shares – but investors can always reduce their ravages, 31 October).

Without exception, an inversion has preceded every recession. Moreover, with just one exception (the interval from September 1965 to March 1967) the curve has inverted only when a recession subsequently occurred.

The inversion has generally presaged the recession by 6-12 months and by as much as two years. Further, the inversion occasionally ceases before the recession commences.

Table 1: Yield Curve Inversions and Recessions in the U.S. since January 1960

The implication is clear: it’s possible that the inversion since August 2022 won’t augur a recession. But if the past is prologue, that’s very unlikely. On past form, and given that the inversion commenced late last year, the recession will commence in ca. 6-12 months’ time.

How and Why Does the Yield Curve Invert?

How does an inversion occur? Logically, there are two possibilities: either the short-term yield rises or the long-term one falls. Reality, of course, is messy; consequently, we shouldn’t be surprised to observe some combination of the two.

Krugman’s Explanation

In The New York Times, on his blog and elsewhere over the years, Paul Krugman has alleged that bond investors’ changing expectations about long-term interest rates determine the yield curve’s slope. On his blog (27 December 2008), for example, he wrote: “the reason for the historical relationship between the slope of the yield curve and the economy’s performance is that the long-term (Treasury yield) is, in effect, a prediction of future short-term rates. If investors expect the economy to contract, they also expect the Fed to cut rates, which tends (by reducing long-term rates) to make the yield curve negatively sloped. If they expect the economy to expand, they expect the Fed to raise rates (causing long-term rates to rise and) making the yield curve positively sloped.”

And in “From Trump Boom to Trump Gloom” (The New York Times, 15 August 2019), Krugman added: “an old economists’ joke says that the stock market predicted nine of the last five recessions. Well, an ‘inverted yield curve’ – when interest rates on short-term bonds are higher than on long-term bonds – predicted six of the last six recessions. And a plunge in long-term yields, which are now less than half what they were last fall, has inverted the yield curve once again, with the short-versus-long spread down to roughly where it was in early 2007, on the eve of a disastrous financial crisis and the worst recession since the 1930s.”

Krugman has repeatedly contended that the yield curve flattens and inverts before a recession because the LONG-term yield plummets. But as Figure 2 clearly indicates, that’s usually not true: the curve inverts before a recession primarily because the SHORT-term rate zooms.

Figure 2: Three-Month and Ten-Year Treasury Yields, Monthly, January 1960-June 2023

Table 2 substantiates this result: of the nine inversions of the yield curve since 1960, only two have resulted principally from a decrease of long-term rates – and seven from an increase of short-term rates.

Table 2: Yield Curve Inversions since January 1960 – Changes of Short-Term and Long-Term Rates

An Explanation That Fits Reality

In contrast to Krugman’s assertion, the “Austrian” theory of the business cycle – named in honour of its founders, Austrian-born economists such as Friedrich Hayek and Ludwig von Mises – conforms very well to reality.

What causes the yield curve to invert? It’s not investors’ expectations about long-term yields; it’s the central bank’s manipulation of short-term yields.

In this framework, the central bank’s policy of “easy money” and resultant artificially low rates of interest launch the unsustainable boom. Crucially, however, the central bank exerts much more influence upon short-term than long-term rates. As Krugman correctly stated in The New York Times (15 August 2019), “the Federal Reserve basically controls short-term rates, but not long-term rates ...”

However, unintended effects (such as unacceptably high rates of consumer price inflation) usually accompany the artificial boom. Accordingly, when the central bank eventually changes course and abates or even reverses its policy of easy money, rates – particularly the short-term rates the central bank controls – rise and the economy stagnates and perhaps busts.

How does the central bank implement its policy of easy money, suppress short-term rates of interest and thereby launch the boom? The details are complex but the gist is simple: it accelerates the rate of increase of the money supply above its historical average. How does the central bank reverse course? It decelerates the growth of the money supply below its long-term mean – and on rare occasions shrinks it in absolute terms.

Since the early-19^th century, economists have identified changes of the supply money as key drivers of the business cycle. An increase via the central bank’s open market operations typically suppresses short-term rates of interest; in turn, lower rates tend to generate more investment and place more (borrowed) money into the hands of consumers. Businesses respond by ordering more raw materials and increasing production. The increased business activity lifts the demand for labour.

The opposite occurs if the supply of money decreases or its rate of growth sharply decelerates: central banks increase their policy rates and short-term market rates rise; commercial banks “call” some existing loans and extend fewer new ones, and thereby crimp credit; in response, businesses curtail exiting and delay or cancel new projects and trim output; hence consumer confidence and spending sag.

Using data compiled by the Federal Reserve Bank of St Louis, Figure 3 plots my approximation of the Austrian “true money supply” (TMS; for details, see Joseph Salerno, “The ‘True’ Money Supply: A Measure of the Supply of the Medium of Exchange in the U.S. Economy,” Austrian Economics Newsletter, Spring 1987). In brief, this approximation is M2 minus time deposits, retail money-market funds and Treasury deposits with Federal Reserve banks.

Figure 3: Percentage Change of Money Supply, Monthly Observations and Rolling 12-Month Periods, January 1960-June 2023

On average since January 1960, the supply of money has risen 7.2% per rolling 12-month period. On rare occasions, it zooms; the interval from April 2020 to June 2021, when it rose at twice or more its average rate (and by as much as 30% in the 12 months to February 2021) was one such instance.

On other rare occasions, the supply of money contracts; the interval since November 2022, when it has shrunk (by as much as 7.6% in the 12 months to April) is one such an occasion. Indeed, at no time since 1960 has the supply of money contracted for as long and by as much as it’s shrinking now.

Why should a contraction of the supply of money – and why in particular should the current unprecedented shrinkage – concern investors? As Figure 4 shows, rolling 12-month percentage changes of TMS correlate reasonably well (R² = 0.36) to 12-month changes of the yield curve’s slope. The curve’s inversion, in turn, reliably anticipates recessions; and recessions typically clobber shares.

Figure 4: Annualised Growth of Money Supply and Yield Curve, U.S., January 1960-June 2023

An unprecedented (since before 1960) contraction of the money supply has caused the steepest inversion of the yield curve in more than 40 years. Does this inversion presage a severe recession and a nasty bear market?

According to Robert Murphy (“The Inverted Yield Curve and Recession,” Mises Wire, 13 June 2022), “... when the money supply grows at a high rate, we are in a ‘boom’ period and the yield curve is ‘normal,’ meaning the yield on long bonds is much higher than on short bonds. But when the banking system contracts and money supply growth decelerates, the yield curve flattens or even inverts. It is not surprising that when the banks ‘slam on the brakes’ with money creation, the economy soon goes into recession.”

“In summary,” Murphy concludes, “the standard Austrian explanation of the business cycle has, as a natural corollary, a straightforward explanation for the apparent predictive power of an inverted yield curve.”

What about Australia?

Using data collated by the RBA, Figure 5 plots my approximation of TMS. Although there’s no Australian equivalent of the NBER, which marks the turning points of contractions and expansions, rolling 12-month percentage changes of the supply of money correspond well to commonly-accepted interpretations of the business cycle.

Figure 5: Percentage Change of Money Supply, Monthly Observations and Rolling 12-Month Periods, January 1960-June 2023

The money supply shrank from June 1961 to February 1962 (by as much as 7.1% in the year to July 1961). This episode, commonly known as the “credit squeeze,” triggered a recession (see Table 2). Money supply also decreased from July 1965 to March 1966 (but didn’t cause a recession), July-December 1974 (a time of recession), and January-March 1990 (which preceded the recession of 1991-1992). Unlike the U.S., the GFC didn’t cause a recession in Australia; in 2007-2009 the supply of money continued to expand (its rate of growth did, however, decelerate to 1-2% per year in 2010 and again in 2012).

Since February of this year, however, the supply of money has been shrinking – by 3.4% in the 12 months to April. That’s the sharpest contraction since September 1974.

What about the yield curve? Using quarterly data, Figure 6 plots the 10 year-three month curve since 1969 (I use the three-month bank bill swap rate to proxy the 90-day Commonwealth Treasury yield). It inverted from the July quarter of 1973 to the October quarter of 1974, which preceded the recession of 1974-75; from the April quarter of 1980 to the July quarter of 1982, which preceded the recession of 1982-83; and from the April quarter of 1988 to the April quarter of 1991, which preceded the recession of 1991. Although Australia didn’t suffer a recession as a result of the GFC, the yield curve inverted from the October quarter of 2006 to the October quarter of 2008; it also inverted, albeit mildly, during the January 2012-April 2013 quarters.

Figure 6: Commonwealth Treasury Ten-Year Bond Yield minus BBSR, Quarterly Observations, July 1969-June 2023

During the past 12 months the curve has flattened and inverted: its slope was 2.0% in April 2022, 0.15% in January 2023 and -0.6% in April; it’s presently ca. -0.45%.

For the sake of brevity, I’ve omitted the Australian counterpart of Figure 2. But what’s true there is also true here: changes to short-term yields, and not to long-term yields, are the primary driver of the curve’s inversion. I’ve also omitted a counterpart to Figure 4; but although the correlation of growth of money supply and slope of yield curve is weaker (R² = 0.24), it’s still significant.

Table 3: Contractions of Money Supply, Yield Curve Inversions and Recessions in Australia since January 1960

Table 3 lists (1) the five occasions since 1960 when the money supply has shrunk; (2) the eight intervals since 1969 during which the 10 year-three month yield curve has inverted; and (3) the five recessions – that is, instances of two or more quarters in which CPI-adjusted GDP falls – since 1960.

A shrinkage of the money supply preceded three of the five recessions, and an inversion of the yield presaged all but one (June-December 2020) of the recessions. Yet on one occasion the money supply shrank, and on four occasions the yield curve inverted but no recession subsequently occurred.

Nonetheless and most significantly, on both occasions when the money supply contracted and the yield curve inverted (i.e., in July-December 1974 and April-November 1982), a severe recession ensued. This result implies that the contraction and inversion are jointly sufficient conditions of recession; if so, then Australia will succumb during the next 6-12 months.

Conclusions and Implications

Is Australia approaching a recession? Is the U.S. facing a slump? Bearing in mind (and as I detailed in America’s permanent recession: Is it coming to Australia? 19 April 2022) that at least one-quarter of Americans and a rising percentage of Australians have long been doing it very tough, Leithner & Company continues to take these possibilities very seriously – and is investing accordingly. “The economic picture is confusing at the best of times,” Shane Oliver humbly and sagely writes (Why you need to know the difference between leading and lagging economic indicators, 25 July). “Yield curves” and “money supply” rightly head his list of leading indicators. 

For more than 20 years, Leithner & Company has constantly investigated extremes in markets; today, these two leading indicators are flashing acute warning signals.

The supply of money rarely contracts, but presently it’s shrinking faster than at any time since 1974 (Australia) and at a rate that exceeds anything since 1960 (U.S.). This monetary shrinkage has impacted credit markets: each country’s 10 year-three month yield curve has inverted – and for the past 50-60 years in each country, the confluence of contraction and inversion has been a perfect predictor of recession.

Economically and financially, the future is always dimly lit. “But with a body of reliable theory,” James Grant said in 1996, “you can anticipate where the structures might lie and step out of the way every once in a while.” You’re less likely, figuratively speaking, to stumble in the dark over chairs and nightstands. “You can begin to visualise in the dark,” he added, “which is where we all work.”

In The New York Times (14 July), Paul Krugman stated that “the economy would have to fall off a steep cliff very soon to make (predictions of recession) right.” I agree: one of us is correct and the other is mistaken, and during the next 6-12 months it should become clear who’s correct and who’s mistaken. “There’s little hint in the data” that the economy will soon tank, Krugman concluded, “... so it sure looks as if economists (have) made a bad recession call.”

I disagree: the theory and data I’ve presented are warning that a slump is coming. It thus seems to me that Krugman’s “all-clear” is premature.

But it’s vital to keep an open mind, and thus to acknowledge that he and the apparently rising numbers of people who’re discounting the possibility of recession, or touting a “soft landing,” could be right. The past is hardly an infallible guide to the future. That’s why forecasts, to put it mildly, should be assessed cautiously and sceptically. As I wrote in How we’ve prepared for the next bust (22 November 2022), if a recession doesn’t occur this year, “it’ll be forecasters’ biggest blunder since their collective inability to detect the GFC until after it had already erupted.”

Indeed, and given that I recently concluded that a recession in the U.S. commenced at the start of this year (see Why America’s now in recession – and what it means for Australia, 9 June), if Krugman’s right then I’ll number among the blunderers.

What if the U.S. succumbs to recession but Australia doesn’t? For equity investors in this country, it’s vital to understand that this is a distinction without a difference: a recession there typically clobbers shares here.

Above all, for conservative investors the assessment of recession’s costs and risks is imprecise but nonetheless ultimately very simple: the opportunity cost of anticipating a slump that doesn’t eventuate is small and transitory; but the absolute cost of failing to prepare for one that does appear is considerable and long-lasting. Mind the downside and the upside will mind itself (see also Recessions usually crush shares – but investors can always reduce their ravages, 31 October 2022).

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