The domino effect
“This is exactly what you would expect, that the yield curve [in bonds] is telling us—that the Fed has raised rates substantially, that causes hardships for banks, which then feeds through for higher interest rates and tighter lending standards, less lending. And, as a result, then consumers stop borrowing because of higher interest rates, and then even more pressure from stress in the banking system. And that all means that we’ll ultimately end in a recession, we think in the latter half of this year, early next year.” – Dr. Gerald Cohen, Kenan Institute of Private Enterprise.
CHAPEL HILL – “Something has broken” in the US economy – and that’s bad news, warns Gerald Cohen. A “hard landing” is on the way.
People hoping for a “soft landing” – a slowdown without a recession – of the U.S. economy as the Federal Reserve fights inflation with ever higher interest rates likely won’t see one, says chief economist at UNC-Chapel Hill’s Kenan Institute of Private Enterprise.
Cohen sounded the warning at the Institute’s monthly virtual press briefing Friday morning, addressing just-released job report numbers. Cohen echoed the Institute’s prediction from last month: the economy is heading toward a recession. The U.S. added 236,000 jobs – fewer than analysts had predicted – and Cohen noted: “So rising interest rates have taken a toll but as I mentioned the timing of this report means we may not be seeing the full extent of the employment, of the challenges in the financial sector.”
The “broken” pieces Cohen referenced include Silicon Valley Bank (SVB) – recently folded and now owned by Raleigh-based First Citizens Bank, plus Signature Bank, and “cracks in the financial system.”
The failure of the two banks sparked the biggest banking crisis since 2008, fueling concerns about an upcoming recession and leading to significant volatility in the banking sector. JP Morgan Chase CEO Jamie Dimon issued similar warnings earlier this week.
Cohen also said interest rates haven’t peaked. “I’m going to say provisionally that we haven’t seen the last rate hike,” he explained. “But but there’s a bit of dynamism in that.”
Another issue on the inflation front: workers’ ability to get raises and thus keep up with prices.
“It’s interesting because the labor markets is still quite tight, but it looks like you’re seeing some slowing, which means, maybe, there is some weakness showing up in people’s ability to bargain for higher wages.”Cohen explained. “The Fed will look at this as a positive because you’re not seeing this wage push inflation that they’ve been worried about. But it’s notable that inflation-adjusted earnings are roughly zero. So if you take the 4.2% year on year changes in wage growth, and you compare it to four and a half percent inflation, you’re basically still negative, so workers are having a hard time making ends meet, which again, pushes on the recession, because they’ll slow their spending as we saw in the month of February.”
According to Cohen, the Institute views those “cracks” and other economic indicators as signs of a looming recession.
“That supports our hard landing view,” said Cohen.
Investopedia defines the term “hard landing” as “a marked economic slowdown or downturn following a period of rapid growth.” The term is borrowed from aviation, “where it refers to the kind of high-speed landing that—while not an actual crash—is a source of stress as well as potential damage and injury.”
When an economist predicts a hard landing, it is a warning that the economy could be heading toward a significant downturn.
“That said, we are not, you know, we don’t think the recession is going to be deep,” said Cohen in the briefing. “We just believe that we’re going to have a fairly mild recession, but we are headed for a recession.”
Focusing on the yield curve
Cohen also referred to a well-known economic indicator called the “yield curve,” which measures the difference between the interest rates of short-term and long-term U.S. Treasury bonds.
“My favorite economic indicator is the spread between 10-year treasuries and 3-month treasuries,” said Cohen.
According to the Federal Reserve Bank of St. Louis, when the spread between these two types of bonds becomes very small or even negative, it can indicate that investors have lost confidence in the economy’s future and that a recession may be looming.
“It turned negative at the end of last year,” said Cohen. “We had not been saying a recession until then, and we started saying a recession when a lot of people were starting to say the opposite—people were talking about no landing.”
In other words, when the spread between 10-year and 3-month treasuries turned negative at the end of last year, the Institute saw that as a warning sign for the economy.
A negative yield curve is concerning because it can lead to higher interest rates, which can then lead to decreased spending and investment.
Like the first domino to fall, a negative yield curve could start a chain reaction that ultimately leads to a recession.
“This is exactly what you would expect, that the yield curve is telling us—that the Fed has raised rates substantially, that causes hardships for banks, which then feeds through for higher interest rates and tighter lending standards, less lending,” said Cohen. “And, as a result, then consumers stop borrowing because of higher interest rates, and then even more pressure from stress in the banking system. And that all means that we’ll ultimately end in a recession, we think in the latter half of this year, early next year.”