With the Federal Reserve taking an increasingly hawkish approach to tackling the highest inflation in 40 years, a growing number of Wall Street banks are forecasting an economic recession in coming years.
Goldman Sachs, Deutsche Bank and Bank of America are among the firms predicting an economic downturn within the next two years as a result of the Russian war in Ukraine, soaring consumer prices and aggressive monetary policy tightening.
But recessions are notoriously difficult to predict: One telltale sign that consumers should watch for, according to a recent Wells Fargo analysis, is an inversion of the slope between the 10-year Treasury yield and its 1-year counterpart. That has not happened since March 2020, shortly before the COVID-19 pandemic shut down a broad swath of the economy and triggered a recession.
"If investors want to select a single yield curve spreads as a signal, we favor watching for when the 1-year U.S. Treasury yield exceeds the 10-year U.S. Treasury yield – by more than 25 basis points, and for at least four consecutive weeks," the Wells Fargo analysts wrote.
Yield curve inversions, which are rare, are viewed as a good recession predictor because it suggests that investors believe – with the interest rate on long-term bonds lower than the rate on short-term bonds – economic growth is slowing.
Yields on the 10-year Treasury note are hovering around 2.86% as of Friday morning, still well above those on the 1-year bond (which are around 2.06%). The spreads between the 5-year and 10-year Treasury, as well as the 2-year and 10-year Treasury, inverted last month.
Every recession in the past 60 years was preceded by an inverted yield curve, according to research from the Federal Reserve Bank of San Francisco.
There are growing fears on Wall Street that the Federal Reserve could inadvertently trigger a recession as it takes a more aggressive approach to fighting inflation, which is at the highest level since December 1981. Policymakers raised rates by a quarter-percentage point in March, and have since confirmed that sharper, half-point increases are likely in the coming months, beginning in May.
"It is appropriate to be moving a little more quickly," Fed Chairman Jerome Powell said last week during a panel discussion at the International Monetary Fund and World Bank spring meetings. "I also think there’s something in the idea of front end-loading whatever accommodation one thinks is appropriate. So that points in the direction of 50-basis points being on the table."
Traders are now pricing in a 100% chance of at least a half-point rate jump when policymakers meet on May 3-4. It would mark the first time since 2000 that the U.S. central bank raised the federal funds rate by 50 basis points.
Some economists believe the Fed waited too long to confront the burst in inflation, while others have expressed concerns that moving too quickly to stabilize prices risks triggering an economic recession. Hiking interest rates tends to create higher rates on consumer and business loans, which slows the economy by forcing employers to cut back on spending.
Powell has pushed back against concerns that further tightening by the central bank will trigger a recession and has maintained optimism that the Fed can strike a delicate balance between taming inflation and not crushing the economy.
Still, he acknowledged the difficulty of the task ahead and said it is "absolutely essential" for central bankers to restore price stability.
"Our goal is to use our tools to get demand and supply back in sync, so inflation moves back into place, without a slowdown that amounts to a recession," Powell said. "I don't think you'll hear anyone at the Fed say that's straightforward and easy. It's going to be challenging."