With the economy suffering from inflation and unanticipated war, March brought a bright spot by giving us improving labor market data and a bounce in financial markets. In our monthly market update, I want to highlight the improving labor market and a warning signal that’s currently flashing.
Labor Market Improves
The labor market has recovered fast in this post covid expansion. You can see the speed of the recovery in the chart above. A typical recession takes an average of 14 quarters to reach full employment; however, this post covid labor market recovery has happened in half the time. Today, the unemployment rate sits at 3.6%, close to the pre-pandemic level of 3.5% in Jan 2020.
Despite this speedy recovery, many business owners are still citing a shortage of labor which could signal more hires to come. The labor shortage can best be seen by the record number of job openings (11.26 million) vs those looking for work (5.9 million). This gap could be due to a mismatch in skills as many jobs are disproportionally opened in areas hit hardest by covid, such as Leisure and Hospitality. However, another reason for this significant divide could be the declining labor force participation rate. Currently, the labor force participation rate is at 62.3%, meaning 62.3% of the people who should be working are working. The participation rate is trending lower due to an aging population and a turn to autonomous technologies. As more baby boomers retire and companies invest in new technologies, old jobs will cease to exist. However, although the baby boomers are retiring, the prime-age working population ages 24-55 continues to recover, providing a stable workforce for the US economy.
Warning Sign: Yield Curve
Before we dive into why the Yield Curve is a warning sign for a potential recession, let’s define the yield curve. Simplistically, the yield curve shows current US Treasury market rates at different time maturities. For example, as of April 1st, 2022, a seven-year US treasury bond yielded 2.50% while a 30 year US Treasury bond yielded 2.44%. Typically, short-term maturities yield less than longer-term maturities. The reason for this is duration risk. Duration is simply a measure of time. A shorter time period usually comes with a lot more certainty creating less risk and generating a lower level of return. In contrast, a longer time period comes with greater uncertainty creating more risk and generating more return.
Today we have an interesting makeup in the yield curve. Specifically, several shorter-term maturities are yielding more than some longer ones. Specifically, the three-, five- and seven-year treasuries are greater than the 30-year, while the 2-year treasury yields more than the 10-year Treasury. Historically, this inversion has been a reliable recession indicator hence my warning signal. Below is a chart of the 10-year Treasury minus the 2-year Treasury.
You can see that when the 2-year Treasury yields more than the 10-year Treasury a recession tends to follow. This has happened in all of the last four recessions which are highlighted in gray. However, the inversion today looks a little different from the rest. In prior recessions, both the 2-year Treasury and the Federal Funds Rate (the rate set by the Federal Reserve) yielded more than the 10-year Treasury. However, today only the 2 year is yielding more. The Fed Funds Rate is still well below at 0.50% whereas the 10 year is at 2.38%, almost 1.9% higher. Coincidentally, the Fed has forecasted a 1.90% federal funds rate at the end of this year. So, it’s possible the Fed could invert the yellow curve later this year.
Many market strategists are citing this difference as a reason to remain bullish however, I’m not convinced. I currently see this divergence as a signal that the Federal Reserve waited too long to raise interest rates. Now that they’ve begun raising rates, the clock has started ticking at how long before the Fed Funds Rate yields more than the 10 year and the next recession begins. Time will tell, but we believe this is another reason to remain cautious throughout 2022.
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|Data Provided by Yahoo Finance||As of 4/1/2022|
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