Is the UK heading for recession?
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There have been a lot of headlines lately about the “yield curve inversion”, claiming this means that recession is coming. Yet what is the “yield curve”, exactly, and what can this – and other economic indicators – tell us about whether a recession is coming or if, indeed, we may already be in one? In this guide, our financial planners at Castlegate in Grantham, Lincolnshire offer some thoughts.
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What is the “yield curve”?
At its heart, the yield curve is about interest rates – how much it costs the government to borrow money from lenders (e.g. bond investors). The “yield” on a bond refers to the profit (interest) a bond investor makes for lending to the government.
Just like a bank loan to a consumer, each bond has a maturity date when the principal amount must be repaid to the lender. In general, a shorter-term bond will have a lower interest rate than a long-term bond (which involves more risk and waiting for the investor).
From here, we can start to understand the yield curve. As bond maturity periods increase, the interest rate (yield) rises. On a graph, this is represented by a curve upwards.
An inverted yield curve happens when interest rates on short-term bonds exceed those on long term bonds. Since 1965, when this happens it has, indeed, historically preceded a recession (e.g. 1974 and 1980). However, it does not always happen and is not an “iron law” (for reasons explained below).
Why does the yield curve go inverted?
The yield curve can invert because Interest rates on bonds are driven by investor demand. If more people want to buy 10-year US Treasuries, then the interest rate will go down. If, however, demand for short term bonds remains static or drops, then it is possible that investors can earn more profit from these bonds compared to long term ones.
This is what has happened recently – albeit briefly. At present, it is now fairly flat again. Yet this has not stopped alarmism in many media headlines.
Does inverted yield curve always mean recession?
An inverted yield curve is a negative indicator of recession. However, it is not the only factor determining recession likelihood. Other forces like high employment, rebounding consumer spending and banks underwriting more business loans can push an economy towards growth, even with a yield curve inversion.
This is why it is important to take headlines about recession with a pinch of salt. The danger is that investors believe them, and focus only on negative indicators of recession (e.g. tightening of credit availability) – ignoring positive ones. This can lead to “confirmation bias” and unwise investment decisions based on fear, rather than solid information.
The Sahm Rule – a better indicator?
If investors want to know the likelihood of a recession, a much more robust model is found in Claudia Sahm’s work, the “Sahm Rule”. This uses a single input – the rate of unemployment (i.e. the percentage of people out of work compared to the entire workforce).
The Sahm Rule claims that a recession (a significant decline in general economic activity lasting over two months) starts when unemployment rises sharply. Whilst the model is not completely predictive, when applied to the US this trend can be seen at the start of every recession since the 1950s – with no exceptions.
Applying the Sahm Rule in the UK, however, does not work quite as well. There are lots of “false negatives” (e.g. 2007, before the Financial Crisis). This may be partly due to varying definitions of what constitutes a recession.
What is the UK recession outlook for 2022?
The Sahm Rule case study in the UK should serve as a strong warning for investors to take lightly headlines about impending recession.
Some organisations like NIESR (National Institute of Economic and Social Research) argue that the UK could be heading for a recession in the second half of 2022. This is partly due to rising living costs (e.g. food and energy). However, it is important to remember that there are still many positive indicators in the UK economy (e.g. employment is still high (75.5%) and the FTSE 100 is up from 12 months ago).
If a recession does transpire, however, it is important to put it in perspective – despite how worrying this may sound. They do not necessarily entail economic disaster. Indeed, they can be an opportunity for a “correction” or “clear out”.
For instance, when house prices fall this is often unwelcome for homeowners, yet it can allow younger people to get onto the property ladder. Most recessions last for a year or so (although after WW1 the recession lasted 3 years).
Conclusion & invitation
The important thing is for investors to stay calm and stay true to the long-term investment plan agreed with their financial planner.
If you are interested in discussing your own financial plan or investment strategy with us, please get in touch to arrange a no-commitment financial consultation at our expense:
01476 855 585
info@casfin.co.uk
