This will not be an economic treatise on the current shape of the yield curve, nor on the prognosis nor probability of a recession.  There have been more than enough articles written in recent months (and more surely to come) opining on the continued flattening of the curve as short rates have moved higher with the Fed increases while the longer-end of the interest rate spectrum has remained relatively muted.  At the same time, many leading economists and ardent market watchers continue to debate if the next economic recession is right around the corner or possibly a few more years down the road.  We all have opinions on the matter, and ultimately someone will be right.  Candidly, one thing I am sure of is that the advent of economic cycles has not been repealed, and consequently the next slowdown is somewhere on the horizon.  In that vein, some historical perspective on the shape of the yield curve and its ability to “predict” the next recession is clearly noteworthy:
An “inversion” of the curve (when short-term rates are higher than long-term rates) has effectively presaged the last five recessions in the United States, as reflected on the above graph.  If the graph were extended to 1955 then this indicator would have captured the last nine economic downturns, while only once, in the mid-1960’s, did this occurrence fail to result in an officially-defined recession (although an economic slowdown did take place).  It should be noted that the magnitude of the inversion does not necessarily correlate to the depth or severity of the recession.  The negative spread between 2-year Treasuries (short-term) and 10-year Treasuries (long-term) was significantly larger in 2000 when compared to instances in 2006/2007, but no one would argue that the recession that followed 2007’s inversion was in any way milder than the economic downturn experienced at the turn of the century.  The last recession didn’t earn the moniker “Great” for nothing.  And again, the yield curve is not currently inverted, but the spread between the short- and long-end (currently around 25 basis points, versus roughly 100 basis points a year ago and nearly 300 basis points in the early years of this decade), has gotten tighter.

The complexities of the global market and the ever-evolving impact of rapid, sweeping technological change make sole reliance on any one historical economic indicator potentially misleading for any business.  In the banking sector, continued prudent, thoughtful oversight of interest rate exposures coupled with ongoing sound and comprehensive system-wide risk management practices designed to ideally stay ahead of coming challenges, will always be the best practice, irrespective of current market conditions and any looming threats.  As JP Morgan Chase CEO, Jamie Dimon, succinctly commented during the bank’s recent 2Q2018 earnings call with analysts and investors:

“There’s a lot of evidence that there’s slack in the system.  Finally, people are going back to the workforce.  The consumer balance sheet is in good shape.  Capital expenditures are going up.  Household formation is going up.  Homebuilding is in short supply.  It is the banking system that’s very, very healthy compared to the past.  Consumer confidence and business confidence are very high, albeit off their highs probably because of something like trade….(i)n history, we’ve had rates going up where we’ve had a healthy environment….(w)e try to manage those risks.  We want more clients.  In almost every business we’re in, we want to do a very good job for them in products and services…(y)ou don’t run the business guessing about when there might be a recession because we know there’s going to be one.”  (emphasis added)

While the economy has been in expansion mode for an extended period of time, uncertainty surrounding the potential unintended consequences of trade tariffs and the ultimate impact of the Fed unwinding its massive $4.5 trillion balance sheet are yet to fully play-out.  The anecdotal commentary surrounding current low unemployment, the impact of recent tax reform and expected GDP growth is being balanced against developing empirical evidence tied to monitoring inflation while the Fed is raising short-term interest rates.  Effectively, the yield curve inverts for all intents and purposes when central banks believe that inflation is headed higher, but the bond market’s sentiments are the exact opposite.

How this will all unfold in the coming months and years remains to be seen.  And a significant unknown lies in the observation that while the Fed has been raising rates on the short-end, with little discernible movement on the long-end, this has all been happening in an already low-rate environment.  How much and how quickly the economy slows (and for how long) is a bit of a wild card.  While the Fed assesses and implements expected interest rate hikes as we move through 2018 and beyond, a continued ardent focus on credit and interest rate exposures remains the order of the day.  Let the talking heads pontificate on the shape of the yield curve and what all of this may mean as a potential harbinger of a downturn.  For the bankers, disciplined business development and prudent execution aligned with a pragmatic risk management architecture continues to be the best game plan.

ProBank Austin brings a multitude of experience, expertise and market knowledge to the table for our clients, spanning broad geographic swaths of the banking industry across this country….and the strong desire to continue to deliver that insight and value-add to all of you in the future.  Please do not hesitate to reach out to me and/or any of my colleagues if we can ever be of assistance as you take your organizations forward and assess the competitive landscape.

In closing, attached please find our monthly summary of Michigan’s financial institutions.  Best wishes for a prosperous and successful 2018!

CLICK FOR THE JULY 2018 MICHIGAN BANK SUMMARY

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