Data Versus Reality: How a Soft Landing Could be a Mirage (July 26, 2023)

If the yield curve is wrong this time, it may be for the wrong reason

By Lisa Beilfuss
July 26, 2023

Investors and economists are increasingly sure the Federal Reserve will achieve a rare soft landing. Could this time really be different?

Two propositions underpin the soft-landing logic. First, the fact that there hasn’t been a recession yet in the face of 500 basis points of Fed rate increases means there won’t be a recession at all. Second, the logic goes, inflation is gliding back to the Fed’s 2% target and is no longer a threat. Recent indicators support the soft-landing case. Consider the June consumer price index alongside the Atlanta Fed’s GDPNow model. The former rose 3% from a year earlier, the slowest rate of increase since March 2021, while the latter predicts 2.4% growth in the second quarter, up from 2% in the first.

Neil Dutta, head of economics at Renaissance Macro Research, captured the zeitgeist in a research note. “There is only so long one can keep claiming that the recession is just six months away,” he said, calling for recession predictors to admit defeat. Even economists at Deutsche Bank, among the first on Wall Street to predict recession, now say it is now a toss up.

But a soft-landing bet ignores upside inflation risks, including double-digit increases in many commodity prices since the end of May. It overlooks clear slowdown signs, such as ongoing rises in high-yield and leveraged-loan defaults, and it assumes history doesn’t apply as the yield curve inverts to levels not seen in four decades.

Praxis recently spoke with Arturo Estrella, the former Fed economist and professor responsible for discovering that the yield-curve slope is a reliable predictor of economic activity. In particular, he found that the spread between the 10-year Treasury note and the 3-month Treasury bill is a perfect recession predictor, better even than the closely watched spread between 10- and 2-year Treasury notes. Estrella says a negative spread between 10-year and 3-month Treasury rates foreshadows an economic downturn starting between six and 17 months after the first inversion. The first such inversion of this cycle happened in November 2022, about eight months ago.

Estrella is used to impatience and this-time-is-different narratives, both in current abundance. “Every time I see the same thing–people are dismissive,” he says, counting former boss Alan Greenspan among naysayers. “And yet it is always the same. We have had eight incidents of [10-year/3-month yield curve] inversion since 1968, and there is always a recession,” he says.

Aside from serving as a recession signal, the yield curve has practical implications. Barry Knapp, director of research at Ironsides Macroeconomics, warns that the deeply inverted curve needs resolution prior to 2024’s surge in maturing commercial real estate and leveraged loans. Analysts at S&P Global Ratings say the amount of maturing speculative-grade nonfinancial debt will surge to $247.7 billion in 2024, more than double the amount maturing this year. The maturity wall grows to $389.3 billion in 2025, S&P estimates.

To normalize the yield curve, the Fed needs to cut rates by about 300 basis points, to 2.4% from a likely peak of 5.5%, economists at SMBC Nikko Securities say. In other words, interest rates that remain elevated into the surge in maturing debt would only exacerbate a recession that Estrella’s gauge says is 99.87% likely to happen in the next 12 months.

If the yield curve is wrong this time, it might be for the wrong reason.

Economist and fund manager Daniel Lacalle suggests the U.S. economy is already in recession. Official data don’t reflect it, he says, because government spending is disguising a private-sector downturn and declines in real, or inflation-adjusted, disposable income, real wages, and small-business margins.

Data from SMBC Nikko economist Troy Ludtka illustrates Lacalle’s point. Real, post-tax disposable personal income has fallen a record 9.7% since the economy exited the pandemic recession, meaning U.S. households are poorer now than they were in the spring of 2020, Ludtka says.

Government expenditures square Ludtka’s observation with still-robust GDP prints. Such spending comprises 35% of U.S. output. Data from the St. Louis Fed show that while that GDP share is down from a pandemic high of 54%, it is still above pre-Covid levels and has been climbing for the past three quarters.

When the government “continues to consume wealth and spend, gross domestic product does not show a recession even though consumption and private investment in real terms is declining,” Lacalle says. One might argue it is good, or at least neutral, if government spending goes straight to consumers and businesses. But it is zero sum. “The flip side of ‘no official recession yet’ is more public debt,” where deficit spending inevitably means higher taxes and lower real wages, he says.

A decline in money supply is core to inflation optimism and soft-landing prospects. M2, a broad measure of money supply that includes cash, savings deposits and balances in retail money-market funds, exploded 43% during the pandemic. M2 fell at record rates in late 2022, but given the huge base it is down just 6% from a mid-2022 high. What is more, it is only half of the money-supply story.

The other half is rising M2 velocity, or the number of times a dollar is spent per unit of time. Lacalle describes velocity as the glue between central bank action, government spending, and inflation, with velocity rising because much of the new money supply funded government spending. If not for the rise in velocity since the fourth quarter of 2021, Lacalle says a money-supply slump of the current magnitude means inflation would be half what it is now.

The point is that as M2 velocity counters the decline in M2 money supply, it threatens to boost inflation numbers and mask private-sector economic weakness in broad growth metrics like GDP.

Money velocity may still have room to run. Michael Ashton, investment manager at Enduring Investments, likens the velocity of M2 to a spring holding potential energy when money rushed into the system. He expects money velocity to bounce to at least pre-pandemic levels, implying a 13% increase or more. It is therefore critical for M2 money supply to keep falling, he says, for inflation progress to continue.

Combine the pieces–the quantitative theory of money where money supply and money velocity are key, Lacalle’s view that government spending is behind rising velocity, and Ashton’s estimates for where it is heading–-and it is possible that official economic data won’t reflect a recession that households and smaller businesses probably can’t avoid.

A soft landing may thus be one in name only.