Is the US heading to a recession?
Possibly….but, the more important question might be how deep will a recession be and how long will it last? Before tackling those issues let’s make sure that we are using the correct definition of what qualifies as a recession. If you are like me, you were taught that a recession was defined as two consecutive quarters of negative GDP growth or contraction. So, was the US in recession in 2022? If you remember, GDP declined or contracted in both Q1 (-1.6%) and Q2 (-0.6%). Objectively, that looked and sounded like a recession, however recessions are not judged by objective standards, rather they are retrospectively declared to have started or ended by the Business Cycle Dating Committee (BCDC) of the National Bureau of Economic Research (NBER). The retrospective view is relevant here as GDP data is gathered with a time lag and the data is always revised – thus, the Committee waits until sufficient data is available to avoid major revisions to the business cycle chronology. A recession, then, as defined by NBER “involves a significant decline in economic activity that is spread across the economy and lasts more than a few months.” So, while there was a period of GDP decline in 2022, the decline was not significant enough to warrant the declaration of a recession.
So, what about 2023? The argument for recession – Yes or No – is equally strong from both sides. On the Yes side we cannot ignore a fully inverted yield curve which currently shows a wide difference between the 10-year US Treasury yield (3.73%) and the 2-year yield (4.71%). The start of the current inversion (spring 2022) coincided with the start of the aggressive monetary policy tightening by the US Federal Reserve. History suggests that a US recession tends to follow a year after the yield curve inverts – this predictor has proven true for 8 of the last 9 curve inversions. Interestingly, the previous inversion was May 2019 almost a year before the Covid shutdown (and deep recession) started in March 2020. While the 2019 inversion did/could not forecast the Covid pandemic, we will never know if the US was poised for a downturn anyway, and the predictive power of curve inversions preserved its strong track record. Curve inversions can cause a recession in two ways. First, inversions do not make sense – borrowing short-term should not be more expensive than long-term – this condition stands in contrast to the basic business model of banks. Second, if we talk about a recession long enough, eventually we talk ourselves into a problem – this self-fulfilling prophecy suggests “risk-off” to investors, deal makers, bankers, and corporate CEOs.
The innate resilience of the US economy in the face of the unprecedented policy tightening by the Fed over the last 15 months has been impressive. In fact, it is the strength of the labor market (current unemployment is a low 3.7%) that may allow the US to avoid recession or limit the downturn both in severity and duration. While initial unemployment claims have moved higher in 2023, monthly non-farm payroll data (the second important criteria used by BCDC) continues to be strong. David Kelly, Chief Global Strategist for JP Morgan, recently offered this “It is this unsatisfied demand for workers, rather than GDP growth over the past year, that has led to strong payroll gains. This excess demand for labor (10 million job openings in US) looks like it may inoculate the economy from declines in payroll employment or substantial increases in the unemployment rate for many more months. A recession that doesn’t lead to a big spike in unemployment means that the subsequent expansion will not benefit from the momentum created by the rapid rehiring of unemployed workers. Adding it all up, the factors that are delaying the onset of a recession probably mean that a recession, when it arrives, will be shallow."