Market Extra: Highly reliable recession indicator could turn ‘code red’ on next Fed rate hike, says pioneering yield-curve researcher

Next week’s widely anticipated rate hike by the Federal Reserve is poised to push one of the Treasury market’s most reliable recessionary indicators into levels that leave little doubt about whether an economic contraction is on the way, according to pioneering yield-curve researcher Campbell Harvey.

He’s referring to the spread between yields on 3-month Treasury bills
TMUBMUSD03M,
3.143%
and 10-year Treasury notes
TMUBMUSD10Y,
3.451%,
the latter of which remained around 35 basis points above the former on Friday. It currently sits at a level that implies only an economic slowdown, Harvey wrote in an email to MarketWatch. An inversion of the spread, in which the 3-month rate moves above the 10-year, has presaged each of the eight past recessions “with no false signals” and that part of the curve could “easily” go “code red” after the Fed’s Sept. 21 rate decision.

Harvey’s comments came as financial-market pessimism deepened on Friday, with stocks selling off on a profit warning from FedEx Corp.
FDX,
-21.48%
and the bond market continuing to flash other warnings of an impending recession. The spread between 2-
TMUBMUSD02Y,
3.854%
and 10-year rates remained deeply negative, at minus 41 basis points, while economists at Wall Street’s most pessimistic bank said they see an almost 5% fed-funds rate on the horizon next year. Traders are pricing in an 84% chance of a 75-basis-point hike by the Fed next week, and a 16% chance of a jumbo 100-basis-point move.

“It appears that the Fed is trying to engineer a recession to eliminate inflation,” Harvey, a finance professor at Duke University in Durham, North Carolina, wrote on Friday. “It is a pity that the Fed needs to induce a recession to make up for their lethargic reaction to early signs that inflation was going to be persistent as well as their inexplicable policy missteps.”

“For example, why continue QE and near zero rates when unemployment was so low and stock prices at record highs? It is baffling. Yet, we all need to pay the price for these actions now. The current inflation is in simple terms a tax. If your wage goes up 3% and inflation is 8%, you have paid a 5% tax,” he wrote.

Harvey is a research associate at the National Bureau of Economic Research in Cambridge, Mass., which makes the official announcements on the beginning and end of U.S. recessions.

He made his mark in the world of research with a 1986 dissertation at the University of Chicago, which linked the difference between long- and short-term interest rates to future U.S. economic growth. In an interview with MarketWatch in April, after the 2-year-versus-10-year spread briefly went below zero, Harvey said that the spread needs to remain inverted for three months to provide a meaningful signal. The 2y10y spread then inverted again in July and has stayed negative for the past two months.

It’s the 3-month/10-year spread, though, that is Harvey’s preferred measure, and even Fed Chairman Jerome Powell has indicated that it’s one of the best starting points for a more relevant read on where the economy may be heading. A history of the 3m10y spread, which captures the shortest end of the Treasury market, shows that a recession could take place anywhere from five months to 21 months from the time of inversion.

In addition, there’s a correlation between the duration of the 3m10y inversion and the length of the recession, with one somewhat linked to the other, according to Harvey.