Investors forecasting a recession are seeing the wrong indicator

Traders work as Federal Reserve Chairman Jerome Powell makes remarks on a screen at the New York Stock Exchange (NYSE) in New York City on March 16, 2022.

Brendan McDermid | Reuters

All eyes are on the yield curve between 2- and 10-year Treasuries, but investors are paying close attention to the wrong signal.

As I have noted before, the authors of the Fed studies of the so-called slope of the yield curve do not consider it to be inverted (and indicative of an upcoming recession) until the three-month Treasury bill yield is by above the 10-year note.

The curve is nearly flat from two-year to 10-year maturities, but that’s not the metric the Fed watches most closely.

Right now, the spread between the three-month bill and the 10-year note is nowhere near inversion. However, if the Fed becomes more aggressive in raising short-term rates, we could get there sooner rather than later.

The lead time between a full reversal and a recession is approximately nine to 15 months. On average, the period is about 12 months.

That means we have a bit of time before we can really worry about an impending recession.

Today’s real-time economic reactions to Fed policy

Consumers react to stricter policy

Pending and Existing Home Salesas well as mortgage applicationshave tumbled in recent weeks with only one rate change announced and in anticipation of bigger and more frequent rate hikes yet to come in 2022.

I have suggested that the Federal Reserve should normalize rates with the strong economy and rising inflation as key factors in its decision tree. However, the speed with which politics now affects the economy would also suggest that the Fed be very cautious in its approach to rate hikes and balance sheet reductions.

Given that fiscal policy is now focused, at least in part, on deficit reduction, an almost simultaneous tightening of monetary policy could, in fact, push the economy into recession, especially given all the other factors of risk facing the economy. These risks range from ongoing war in Ukraine to the renewed Covid lockdowns in China and Restrictions in Hong Kong.

While critics continue to harass the Fed from a political perspective, very few have warned that the most outdated idea is not whether the central bank is behind the curve, but whether the curve now looks more like a fastball.

The problems with the curve are important, but the Fed’s fastballs could take the economy out of the batter’s box.

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