Recession Alert: Sahm Rule and Yield Curve Normalization Signal Potential Trouble

When both the Sahm Rule is triggered and the yield curve has recently un-inverted, it significantly increases the probability of an ongoing or imminent recession.
The normalization of the 2-year and 10-year Treasury yield curve, where it's no longer inverted, typically signals a shift in economic expectations.
 
Historically, this un-inversion has often preceded economic downturns, contrary to what one might intuitively expect. It may indicate that investors anticipate lower short-term interest rates in the near future, possibly due to expected central bank actions to combat slowing economic growth.
 
While this signal has been a reliable recession predictor in the past, its accuracy in the current economic environment is debated due to unprecedented monetary policies and global economic factors. Markets may react with increased volatility as investors reassess their positions. However, the timing between yield curve normalization and potential economic changes can vary significantly, and other economic indicators should be considered for a more comprehensive outlook.
Here's what this might historically indicate and what could be expected:

• Historical Indication: An un-inverted or steepening yield curve after a period of inversion has often been associated with an increased risk of recession. This might seem counterintuitive because one might expect the opposite, but the reasoning lies in the dynamics of interest rates and economic cycles.
  
  
• Economic Expectations:
  • Interest Rates: The un-inversion could suggest that short-term rates are expected to fall relative to long-term rates, which might indicate that the market anticipates the central bank will lower short-term rates to combat an economic downturn.
    
    
  • Economic Growth: Investors might be pricing in slower economic growth or a recession, where they demand higher yields for longer-term securities due to increased risk perception or lower inflation expectations over the long term.
    
    
• Timing and Expectations:
  • Recession Timing: If history is any guide, the un-inversion might suggest that if a recession hasn't already started, it could be imminent. However, the lag between an un-inverted yield curve and an actual recession can vary.
    
    
  • Market Reaction: Stock markets might react negatively to an un-inverting yield curve if investors believe a recession is on the horizon.
    
    
• Current Context: Given the unique economic environment, the yield curve's predictive power might be under scrutiny. Recent analyses suggest that while the yield curve's inversion has historically been a reliable indicator, its un-inversion might not carry the same weight due to changes in how banks operate, the nature of economic cycles, or the impact of quantitative easing and other unconventional monetary policies.
  
  
• Predictive Power: While the yield curve has been a reliable predictor historically, its accuracy has been questioned in recent years due to unprecedented monetary policies.
  
  
• Global Context: International economic conditions and policies might influence U.S. Treasury yields and economic outcomes, adding complexity to the interpretation of yield curve movements.
  
  
• Policy Response: Potential policy responses from central banks and governments could significantly influence the economic trajectory following yield curve normalization.

• Market Sectors: Different market sectors might react differently to the yield curve normalization, as some industries tend to be more sensitive to interest rate changes than others.
  
  
• Inflation Expectations: Changing inflation expectations play a crucial role in yield curve dynamics and subsequent economic outcomes.
  
  
• Structural Changes: Potential structural changes in the economy (e.g., technological advancements, demographic shifts) could affect the relationship between yield curve movements and economic outcomes.
  
  
• Timing Uncertainty: There is significant uncertainty in timing between yield curve changes and economic events, especially given the unique current economic environment.
  
  
• Financial System Stability: The health and stability of the financial system might influence the impact of yield curve changes on the broader economy.
  
  
• International Capital Flows: Changes in international capital flows might affect Treasury yields and complicate the interpretation of yield curve movements.
  
  
• Sahm Rule and Recession Probability: The Sahm Rule, which identifies the onset of recessions based on changes in the unemployment rate, provides an additional perspective when coupled with the un-inverted yield curve:
  
  • The Sahm Rule states that a recession has likely begun when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more relative to its low during the previous 12 months.
    
    
  • When both the Sahm Rule is triggered and the yield curve has recently un-inverted, it significantly increases the probability of an ongoing or imminent recession.
    
    
  • The combination of these indicators provides a more robust signal, as it incorporates both financial market expectations (yield curve) and real economic data (unemployment rate).
    
    
  • However, it's important to note that even this combined signal is not infallible, and economic conditions can still deviate from historical patterns.
    
    
• What Might Happen:
  ​
  • Short Term: There might be a period of uncertainty or volatility in financial markets as investors adjust their portfolios in anticipation of lower growth or a recessionary environment.
    
    
  • Long Term: If a recession does follow, it might lead to lower interest rates, potentially stimulating economic activity through cheaper borrowing costs, assuming other factors like consumer confidence and employment don't deteriorate significantly.

---