The Next Recession - When Will it Occur and How Painful Will it Be?

Throughout modern history, one measure has very accurately predicted the likelihood of a recession.  This measure was pioneered as an indicator of future economic growth by Dr. Campbell Harvey, a Canadian economist who is currently a professor of finance at Duke's Fuqua School of Business.  In a paper entitled "The Term Structure and World Economic Growth" which appeared in the 1991 premier issue of The Journal of Fixed Income, Dr. Harvey postulated that:

 

 "...interest rates provide a window on future economic growth in that interest represents the rate at which people are willing to trade consumption today for, consumption tomorrow.  This rate is fundamentally linked to expectations of economic growth."

 

In this ground-breaking paper, Dr. Harvey states that the shape of the term structure of interest rates (i.e. the difference between short-term rates and long-term rates) in the market will provide a forecast of the levels of future economic growth.  This is largely the case because, like stock market prices, bond prices (and, by extension, interest rates) are forward-looking.  

 

The Federal Reserve Economic Data (FRED) website provides us with the data necessary to examine Dr. Harvey's theory.  First, here is a chart showing the interest rates on 3-month Treasury Bills going back to the beginning of 1962:

 

Note the sharp increase in 3-month interest rates since the beginning of 2022 when the Federal Reserve began its monetary program to defeat rising inflationary pressures in the United States.

  

Here is a chart showing the interest rates on 10-year Treasuries going back to the beginning of 1962:

 

 

Once again, you can see the increase in 10-year interest rates since the beginning of 2022.

 

Now, let's overlay the two charts by subtracting the 3-month Treasury interest rate from the 10-year Treasury interest rate noting that the shaded areas represent recessions:

 

Throughout the past 60 years, just prior to a recession, the 10-year/3-month spread is negative, in other words, the yield curve is inverted with long-term yields being below those of a shorter term.  The current spread is the most negative since the twin recessions that occurred between Q2 1979 to Q3 1980 and Q2 1981 to Q3 1982.  The current spread suggests that a deep recession is likely in the near future, however, the spread does not have the ability to predict exactly when the recession will take place.

  

As an aside, the Atlanta Fed has a model for estimating real GDP growth called GDPNow.  Here is the latest prognostication for the first quarter of 2023 using this tool which is constructed by aggregating statistical model forecasts of 13 subcomponents that make up GDP:

 

On average, the GDPNow model predicts real GDP growth of 2.5 percent for Q1 2023 (up from 2.2 percent in the previous week) with a range of between 0.3 percent and 2.5 percent.

  

Here are the components of the data that is used by the GDPNow model:

 

 

So, will there be a recession?  The GDPNow model suggests that economic growth in Q1 2023 will be fairly robust.  This is in contrast to the current spread between 10-year and 3-month Treasuries which are predicting that there will be a recession in the near future and that it will be a rather deep economic contraction.

But, then again, when did central bankers ever foresee any economic catastrophe, recalling their latest blunder with "transient inflation".

The Next Recession

Given that the current economic expansion is one of the longest on record, one has to wonder when the next recession will occur and what will trigger a cooling of what can only be described as a relatively lukewarm economy.  A recent CRS insight by Marc Labonte at the Congressional Research Service provides us with historical background on the economic cycles that have taken place since the end of the Second World War and how the current economic scenario compares to past pre-recession events.

At 105 months (including March of 2018), the current economic expansion is the second-longest in post-Second World War history as shown on this graphic:

According to the Wall Street Journal's Economic Forecasting Survey, a minority of economists are predicting a recession as shown here:

That said, economists are far better at hindsight than they are at foresight; recessions are generally not visible to the economic world until they are well entrenched.  

Additionally, despite the Federal Reserve's unprecedented and "heroic" monetary experimentation, the post-Great Recession recovery has not matched its predecessors as shown here:

...and here:

This would seem to suggest that there is underlying economic weakness that has not been present in other economic expansions.

Here are a few economic trends that often precede recessions:

1.) Rising Inflation:

In all but the 1953 - 1954 recession, inflation has increased before the recession began as you can see here:

The three most recent recessions were preceded by inflationary increases of under three percentage points compared to five of the eight preceding recessions which saw inflation increase by at least three percentage points.  The recent drop in the increase in inflation more or less mirrors the decline in the size of interest rate increases required to beat back an overheated economy as shown here:

In the case of the current economic expansion, it is entirely possible that the rise in the consumer price index from its low of zero percent to its current level of 2.1 percent could be the sign that the economy is nearing the end of the post-Great Recession expansion phase as shown here:

The doubling of oil prices from the $30 dollar per barrel range to the $60 dollar per barrel range will eventually work their way into the economy just as the rise in oil prices to over $140 per barrel acted as one factor that helped push the global economy into a recession in 2007 and 2008. 

2.) Falling Unemployment:

Since the Second World War, unemployment fell to 5 percent or lower prior to all but two recessions as shown here:

In all but the 1981 - 1982 recession, unemployment was lower than the Congressional Budget Office's estimate of the natural unemployment rate before the recession began.  You will also note that in the six previous economic expansions, the unemployment rate has only fallen as low as the current rate of 4.1 percent in the 1999 - 2000 recession when it hit 3.8 percent in April 2000.  In that cycle, the recession began 11 months later.

3.) Elevated Asset Prices:  In the 1999 - 2000 recession and the Great Recession, economic contraction was preceded by asset bubbles (technology stocks and housing respectively).  In this cycle, particularly since early 2017, there has been a rapid rise in the stock market.  Here is a graphic showing the 12-month real change in the S&P 500:

From this graph, you can see that the upward volatility of the stock market is not necessarily related to the occurrence of a recession, however, each economic cycle is different.  In this cycle, we have not seen the housing market or certain specific sectors of equity markets enter what is colloquially referred to as "bubble territory", however, all of the money that has been injected into the economy by the Federal Reserve may well be playing a role in the very high valuations in the stock market which are now at the second-highest levels since the Second World War when calculated using the ratio of corporate equities to GPD (i.e. the Buffett Indicator) with only the valuations experienced during the technology stock bubble of 1999 - 2000 surpassing the current level.

Recessions are notoriously hard to predict.  As we found in the Great Recession, the economy (at least surficially) appears to be healthy in one quarter and in contraction the next.  Trends in the three factors listed above seem to suggest that an economic contraction could occur at any time, however, as Janet Yellen said in December 2015:

"I think it’s a myth that expansions die of old age. I do not think that they die of old age. So the fact that this has been quite a long expansion doesn’t lead me to believe that it’s one that has—its days are numbered. But the economy does get hit by shocks, and there are both positive shocks and negative shocks. And so there is a significant odd, you know, probability in any year that the economy will suffer some shock that we don’t know about that will put it into recession. And so I’m not sure exactly how high that probability is in any year, but maybe at least on the order of 10 percent. So, yes, there is some probability that that could happen, and of course we’d appropriately respond, but it isn’t something that is fated to happen because we’ve had a long expansion, and I don’t see anything in the underlying strength of the economy that would lead me to be concerned about that outcome." (my bold)

As it turns out, her observations about the advanced age of the current economic expansion was rather prescient.  I suspect that her replacement will not be so lucky. 

What the Business Sector is Telling Us About the Economy

The latest press release from the Federal Reserve shows us the level of confusion that reigns at the world's most influential central bank.  This becomes particularly apparent when we look at what has happened to the dot plots which show FOMC participants' best guess about future interest rates over the past year:

1.) March 2016:

2.) December 2015:

3.) September 2015:

4.) June 2015:

5.) March 2015:

That amount of variation from quarter-to-quarter in their interest rate prognostications would suggest that the Federal Reserve Board Members and Bank Presidents would be just as accurate in their "best educated guesses" if they tossed a dart at a board with random numbers scattered across its surface.

Unlike the eternal optimists at the Fed, those of us who live in the real world are getting a sense that all is not particularly well, a fact that the business world has known for some time.  By merely looking at three charts using Federal Reserve data, a thinking person can see where the economy is becoming increasingly weak and get a strong idea of where it's headed.

Let's start with the dollar value of manufacturers' new orders (excluding aircraft):

You'll notice that prior to the 2001 and 2008 recessions, the dollar value of new orders showed significant levelling off.  In the current cycle, the dollar value of new orders has been more or less level since early 2012 as shown on this graph which shows year-over-year growth in manufacturers' new orders since just prior to the Great Recession:

The data shows us that the dollar value of new orders have actually been declining on a year-over year basis since February 2015, hardly a good sign for strong (or any) economic growth.

Now, let's look at the dollar value of total business sales:

Total business sales have been more-or-less flat since July 2014 and have really not shown much growth since early 2013 as you can see on this graph which shows the year-over-year growth in total business sales since just prior to the Great Recession:

The data shows us that the total dollar value of business sales has actually been shrinking since January 2015.

Lastly, let's look at the business inventory-to-sales ratio, a measure that provides us with a sense of how much inventory is sitting unsold compared to how much is selling (i.e. a low number is better):

At a ratio of 1.4, the inventory-to-sales ratio is at its highest level since May 2009 and prior to the Great Recession, we have to go all the way back to October 2001 to see a ratio that was as high as it currently is.

These three measures, alone, show us how precarious the state of America's economy has become and would suggest that the next recession may be coming sooner than the Federal Reserve projects, throwing out all of their dot plot "best educated guesses".  With the current economic trough to peak cycle of 69 months being significantly longer than the post World War II  average of 58.4 months, we are overdue for another economic slowdown, no matter what "monetary witchcraft" the Federal Reserve has employed or may employ in the future.

In closing, all of this begs the question "Has the Federal Reserve ever predicted a recession or do their powers of observation only allow them to see one in the rear-view mirror?".