The question for interest rates now isn’t if there will be a recession, it is when it will come. The “recession trifecta” as I call it, has occurred; the unemployment rate rising (Sahm rule), Leading Economic Index (LEI) falling materially, and the yield curve inverting. Historically, you need two of these to expect a recession and all three have triggered. I will write about that separately soon.

A recession is coming, but based on historical cutting cycles, the 2-year Treasury yield is priced for an imminent recession (within about three months), but there is a discrepancy to the rising unemployment rate upon which this pricing is mostly based; that initial jobless claims haven’t risen with it. This, along with a rough extrapolation of how fast the labor market is deteriorating and recent economic data improving suggests that Treasury yields will need to rise temporarily to fill this gap.

Amount of Fed cutting expected

Comparing the 2-year yield to the current Fed Funds Target Rate is a good metric for how much cutting or raising the bond market expects over the next two years. The chart below shows this relationship. When the line is positive, it means the bond market expects the Fed to raise rates and conversely, when it is negative, the bond market expects the Fed to lower rates.

On the day before the Fed lowered rates this month, this spread got to a very low level with the expectation that the Fed needed to lower rates a lot, a classic signal of an upcoming recession. You can see that it only compares to levels it reached in 1989, 2001, and 2008, prior to recessions. When this level of Fed cutting expectation is close in-time to the recession (gray bars), like in 2001 and 2008, the 2-year yield was able to continue falling without much volatility. But in 1989, where this cutting expectation occurred a year before the recession, the 2-year rose considerably (1.58%) before falling to new lows in 1990. I don’t think a recession is as far as a year away, as this happened before the unemployment rate had risen materially, but the point is that a recession needs to come along fairly quickly to justify this amount of Fed cutting; to keep the 2-year yield where it is or falling.

Soft-landing cuts?

Some think that the Fed will be able to keep cutting rates ahead of the business cycle; without ever seeing the economy fall; the “soft-landers” as I call them. This would mean the Fed would continue cutting without economic weakness. Austan Goolsbee, president of the Chicago Fed, would probably cut rates to 3% at the next meeting if it were up to him, but ultimately, the Fed is forever bound by needing to see economic weakness as they cut rates to make sure that inflation isn’t going to get out of control. Despite economic theory, the space between here (4.875%) and neutral (~3%) isn’t necessarily safe for inflation. This is why the Fed can never get ahead of the business-cycle. Raphael Bostic, President of the Atlanta Fed, addressed this in an essay on the Atlanta Fed’s Website on Monday,

“…what is the argument for not pushing the policy rate into the neighborhood of neutral as soon as possible? Why not a series of larger moves of, say, 75 or 100 basis points until we reach a range where disputes about the true neutral level are salient? For me, the answer is that there remains some uncertainty about whether we can really be fully confident that both our inflation and employment goals are fully within reach. The path of inflation in 2024 has been choppy, and the unpredictable nature of rents and housing prices still worries me. I will not be comfortable claiming victory if we stall short of our inflation goal, even if virtually all non-housing PCE component prices are increasing at their prepandemic rates.”

The Fed may be able to get away with another 50-basis point cut in November or December without economic weakness (“front-loading” cuts as Christopher Waller says), but they are not going to be able to cut blindly down to neutral without material economic weakness. Inflation often lags the business cycle, and I wouldn’t be surprised to see inflation rise at some point in the next six months in concert with economic weakness. The more the Fed has “front-loaded” cuts, the more this natural phenomenon will appear to be caused by their aggressive cutting; creating a mess for them. Many think the Fed will beat the business cycle this time, but they can’t, not because it is impossible, but because they must worry about inflation too. It isn’t as attributable, time-ordered, and predictable as anyone wants it to be.

It is important to also note that in all 3 soft-landings in the US since WWII (1967, 1985, and 1995), one or none of the recession trifecta that I mentioned at the top happened. In other words, it wasn’t the Fed that created the soft-landing, it was observable ahead of time. My overriding comment about this is that the Fed mitigates business cycles, it doesn’t create or eliminate them. The Fed’s insistence of the possibility of a soft-landing, along with the investment industry’s promotion of the idea has turned it into an assumption and put a lot more stock investors in harm’s way than usual.

Jobless Claims

In the chart below, you will notice that the unemployment rate and initial jobless claims are very well correlated back to 1967 (since initial jobless claims were first published). Rising claims have nearly always been ahead-of (led) the unemployment rate; rising before and during recessions. Notice the yellow line usually rising ahead of the blue line from troughs.

In this cycle, the unemployment rate has risen significantly triggering the Sahm rule, but initial jobless claims haven’t. In fact, claims have fallen over the last two-months by 32k. This gives credence to the idea that the unemployment rate has risen, in part, because of more labor supply (Waller). Yet, the St. Louis Federal Reserve came to the opposite conclusion in research released Tuesday, writing,

“Our analysis of flow components using the previous formula reveals that the primary driver of the recent uptick in the unemployment rate is the increase in the job separation rate to unemployment.”

Either way, the unemployment rate will be suspect until it comports with initial jobless claims. The rise in the unemployment rate is a big reason why the 2-year is priced for a recession.

For those following the vacancy to unemployed ratio (“V/U”) and David Rosenberg’s argument about this, even when this was above 1 (more vacancies than unemployed) before the 1970 recession [Michaillat-Saez], jobless claims rose with the unemployment rate for 6 months ahead of the recession and 10 months ahead of when the V/U ratio crossed below 1 in March of 1970 (green oval in chart above.) In other words, the V/U ratio just now crossing below 1 isn’t an excuse for initial jobless claims to not corroborate the rising unemployment rate.

Economists focus so heavily on the labor market because it predicts consumer spending. The more workers without a job, the less spending and less GDP growth. This is Okun’s Law. The unemployment rate can rise because more unemployed come into the labor force, but initial jobless claims are more specific and not based on a sample. They represent people being laid off which has a direct implication to the slowing of spending and GDP growth. Because consumer spending hasn’t shown weakness yet, for the Fed to cut like a recession, initial jobless claims will need to rise. Eventually they will, given all the other signals of recession, but until they do; the situation presents a gap of time between when the bond market thinks a recession is coming and when a recession will come.

For those wondering if jobless claims eligibility is keeping the numbers lower, both Mary Daly (President of the San Francisco Fed, 24% of US GDP) and Raphael Bostic (President of the Atlanta Fed, 12.4% of US GDP) have said that they aren’t hearing about layoffs from their business contacts yet in the way they have in past recessions.

Non-farm Payrolls

Negative non-farm payrolls numbers, even before revisions, have been a necessary condition to the start of recessions. In each of the prior three (non-COVID) recessions, payrolls fell at or before that recession. This is no surprise because non-farm payrolls falling is one of the big economic indicators the NBER (recession dating group) uses to date the start of recessions. There hasn’t been a negative number yet; the lowest has been +89k.

In the chart below, a rough extrapolation of the deterioration in payrolls towards a negative number suggests a recession starting in March 2025. It won’t be linear like this, but it is another reason to think a recession won’t begin imminently.

Economic Data

Economic data, on-balance, as shown through the Lantern Daily Economic Index (LDEI), has been improving since mid-July (orange arrow in chart below). However, today’s personal income and spending data did bring it down considerably (purple circle in chart below). The short-end of the yield curve has ignored this so far, focusing only on the labor market to expect an imminent recession, but if good economic data persists, yields will need to rise to reflect better economic conditions.

These things together, along with the simple idea that the short-end of the yield curve hasn’t really thought through the reality of Fed cutting timing and, I suspect, is pricing more to the meta (the consistency of past business cycles) than current conditions, tells me that there is a yield back-up ahead until some of these recession “missing pieces” get resolved or a credit/geopolitical-event makes them moot.