Summary: Short-term interest rates could rise as the Fed tries to rein in Fed cutting expectations, but because everything points to a recession soon, don’t expect this yield back-up to extend much more. The greater risk at this point is for another shoe to drop and rates to keep falling.

After last week’s strong Retail Sales number, it is clearer that a recession hasn’t begun yet. The attachment shows the state of the six indicators the NBER uses to date a recession. Economic data gets revised after its first release, but even when it was first-reported, Non-Farm Payrolls falling has been a reliable indicator of the beginning of recessions in 1990, 2001, and 2007-08 (as far back as my first-release data goes.) In July of 1990 (recession start date), payrolls first fell 219k followed by 12 more consecutive months of negative numbers. In March of 2001 (recession start date), payrolls fell 86k followed by 10 more consecutive months of negative numbers. In January of 2008 (one month after the recession is dated), payrolls fell 17k followed by 25 more consecutive months of negative numbers. There hasn’t been a negative payroll number yet, let alone a string of them, making the likelihood that the U.S. is in a recession small.

But the process approaching a recession is well in-tact. The Fed raised rates thoroughly, the yield-curve inverted, and is now close to de-inverting (10-year minus 2-year.) The Leading Economic Index is down 15% from its peak. Most recently, the Unemployment Rate has risen 0.9% from its low and has been accelerating upwards since March. These things only happen before or during recessions, not soft-landings (further detail from recent posts about the Yield Curve, Leading Indicators, and the Unemployment Rate.)

Also, the timing and ordering of market events is standard. Treasury yields peaked (10/2023) three months after the last Fed raise (07/2023.) Leading up to all recessions back since 1949, the 2-year yield peaked within three months before, to three months after the Fed stopped raising rates; an unusually strong consistency. In terms of order, leading up to the past three (non-COVID) recessions, Treasury yields first peak, then the Fed starts cutting, then the recession begins. Assuming that the cyclical yield peak was in October of 2023, and that the Fed’s first cut will be in September; a recession beginning after that would fit with the last 30 years of history. In the last two (non-COVID) recessions (2001 and 2007-08), the recession began 2-3 months after the first Fed cut. That timing would suggest a recession beginning at the end of this year.

And if a recession is coming, the behavior of yields before them is important. Historically, a whole lot of Fed easing gets priced-in early. Fed Funds (currently 5.375%) minus the 2-year yield (4.02%) is a gauge of how much future Fed cutting (or raising) is priced into the market. The 2-year yield is 136 basis points below the Fed Funds Rate which suggests a lot of Fed cutting, but this spread has been more inverted in past cycles before the recession (see chart below.) Well before anyone can see the “whites of the eyes” of a recession, it has planned out a deep Fed cutting cycle.

While there seems to be more Fed cutting priced into the market than fits with the current environment, the lesson from past recessions is that it doesn’t matter; the bond market prices in much more weakness than is visible because it expects a recession ahead. Also, the more recessions that occur with these regularities, the faster the market expects them. It did this wrongly last May (after the banks failed) and December (red circles in chart above), but that was before the Unemployment Rate had risen 0.9% and was accelerating upwards (see chart below.) While most other economic indicators have a less direct implication for the economy, the Unemployment Rate is broadly inversely proportional to GDP growth, enshrined with Okun’s Law. This is logical because as unemployment rises, fewer people have incomes, and consumer spending (68% of the economy) is impacted negatively.

2-year yields tend to drop consistently before and during recessions, making entry points hard to find. Approaching and into the first part of the last three (non-COVID) recessions, backups were relatively small; between 25 and 50 basis points (see charts below.) Larger backups tend to occur further into Treasury bull markets. The back-up in the 2-year so-far since August 2nd is 23 basis points (closing prices, existing peak on 8/15/2024.)

The Fed is doing their best this week to rein in Fed cutting expectations and I expect Jerome Powell’s speech at Jackson Hole tomorrow morning to be more of that theme. This “gradual cutting” theme may achieve more of a backup in interest rates, but history suggests interest rates won’t rise much further before more negative economic data points retake the spotlight.