Professor behind recession indicator with a perfect track record says it remains 'way too early' to call off a US economic downturn

Stronger-than-expected economic data has forced some on Wall Street to push back, or even remove, calls for a recession once widely considered a sure thing.

But one recession indicator is still flashing a code red signal on the US economy: the Treasury yield curve.

The inverted yield curve indicator, which occurs when the yield on three-month Treasury bills exceeds the yield on 10-year notes, is a perfect 8-for-8 in preceding every recession since World War II.

Its inventor, Duke professor and Canadian economist Campbell Harvey, still sees a recession on the horizon even if the economic narrative has skewed optimistic in recent weeks. "It's way too early to say this is a false signal," Harvey told Yahoo Finance. "Way too early."

Because of Harvey's work, investors have long focused on an inverted yield curve as a sign of a pending economic downturn.

Some track the spread between two-year and 10-year Treasury notes for signs of an inverted yield curve. But Harvey's definition uses the difference between three-month bills and 10-year notes, a spread which turned negative nine months ago in November 2022.

Ahead of the last eight US recessions, the average time between an inversion of the yield curve and the start of a recession has been 11 months, per Harvey's research. Over the past four recessions, the average lead time has been longer at 13 months. This time, Harvey sees a recession likely starting in early 2024.

"The longer we go [without a recession] after the inversion, people start to doubt the indicator, which is fine." Harvey said. "I characterize it as a lull before the storm."

'The Narrative Turns'

A 2023 recession was widely forecasted at the start of this year. But that hasn't played out, with the staff of the Federal Reserve recently joining the growing list of market participants that no longer see a recession befalling the US economy.

This conversation has, in part, called into question whether the yield inversion is still a good indicator.

In a July research note titled "The Narrative Turns," Goldman Sachs chief economist Jan Hatzius moved down the firm's likelihood of a recession in the next 12 months to 20% from 25%.

Hatzius cited resilient economic data and cooling inflation as well as noting, "We don’t share the widespread concern about yield curve inversion."

"The argument that the inverted curve validates the consensus forecast of a recession is circular, to say the least," Hatzius wrote.

Not the 'end of the story'

In January, Harvey posted on LinkedIn that he had "reasons to believe" the yield curve was "flashing a false signal."

At the time, he noted key components of the pandemic-era, stimulus-fueled economy remained in play. Excess labor demand, a strongly positioned consumer, and healthy financial sector were all indicating the US may avoid a recession.

"The major wildcard is the Fed," he wrote in early January. "I believe the time to end the tightening is now."

Since then, the Fed has raised its benchmark interest rate by more than 100 basis points to its highest level since 2001.

A regional banking crisis unfolded, culminating with the failures of three sizable banks. That slowed lending from big banks in the second quarter and credit conditions are expected to remain tight through the end of the year.

This, Harvey argues, is key to why the economic slowdown has still yet to come. While a historically low unemployment rate might be something raised in an argument for why the economy remains resilient, that's a lagging indicator.

The yield-curve indicator should be seen as a warning sign for things yet to come.

"A lot of people think of [the yield-curve inversion] as sort of the cause of recessions," Charles Schwab chief investment strategist Liz Ann Sonders told Yahoo Finance. "That's not really one of the ways to think about it. It's the conditions that develop that cause the inversion of the yield curve, that ultimately are the things that cause the contraction in the economy, too."

Both Sonders and Harvey explained that the yield-curve inversion itself means banks are put in a tough spot.

Financial institutions typically borrow short and lend long.

For many consumers, for instance, the interest rate they pay on a 30-year mortgage — long-term money the bank has lent to them — might be below the rate this consumer is being paid for parking cash in a high-yield savings account, money the bank is essentially paying the consumer to borrow.

In the second quarter, for instance, deposit rates being offered by banking giants like JPMorgan (JPM) and Wells Fargo (WFC) rose sharply, pushing interest costs higher at these firms.

Higher rates also pressure the value of assets like mortgages and other long-term loans that may be held on a bank's balance sheet, a dynamic that investors learned all about after the collapse of Silicon Valley Bank.

"That constrains lending and in turn constrains investment and the economy," Sonders said.

Warnings of potential stress in the financial sector have been piling up in recent weeks, too.

On Monday, S&P Global downgraded its bond ratings for several US regional banks. This followed Moody’s downgrading 10 mid-sized institutions earlier this month, and a warning from a Fitch Ratings analyst that the entire industry could be downgraded to A+ from AA-.

"The Fed did not stop [raising rates] and this created other stresses, like on the financial system," Harvey said. "We've seen that realized in March and I don't think it's the end of the story."

Josh Schafer is a reporter for Yahoo Finance.

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