Trump and the inverted yield curve

August 16th, 2019

2 to 10 year yield spread

President Trump would seem to have an advantage over whoever the Democrats select as his 2020 challenger: since the Second World War, nine elected presidents have sought a second term, and seven of them succeeded.

The two exceptions were Jimmy Carter in 1980, and George H. W. Bush in 1992. In both cases, the US economy was performing badly in the lead-up to the election. US voters seem to be indulgent towards their incumbent presidents, but less so if jobs are being lost. In 1980, the Ronald Reagan was able to attack Carter with a memorable line: “A recession is when your neighbor loses his job. A depression is when you lose yours. And recovery is when Jimmy Carter loses his”. In 1992, Bill Clinton’s campaign was similarly focused on the recession then affecting the USA: “It’s the economy, stupid”.

As Trump is fond of telling us, so far the US economy has been doing well under his watch. Unemployment is historically low, and consumer spending has held up well. The long recovery and bull market which followed the 2008/9 financial crisis have continued into his term, boosted by historically low interest rates, tax cuts, and Trump’s sensible decision to make it more attractive for US companies to repatriate foreign profits.

But there is a warning sign flashing a very strong danger signal for the US economy. The graph shows the difference between the interest rates on ten-year and two-year Treasury bonds. Usually this is positive – you get more interest for locking your money away for a long period, but it has just gone negative. Historically this ‘inversion of the yield curve’ has been a very good indicator of impending recession: not only has it preceded all economic downturns since WWII, but also it hasn’t given any false signals, as can be seen on the graph above where recessions are shaded in grey.

What should worry Trump most is that in each case there has been a lag, of around 6 to 18 months, between the curve inverting and the US economy entering recession. If that correlation holds, voters could be casting their votes just as the economy worsens considerably. Given Trump’s dependence on support from blue-collar workers in the central industrial belt, that could cost him his second term.

Of course there is one easy thing he could do to help avoid this. Economists don’t know much, but they do know one big thing: there are no winners in trade wars, only losers. If Trump wants to be re-elected in 2020, he’d better get on the phone to President Li and do a deal to cancel the spiral of competitive tariffs which China and the US are imposing on each other, and which is damaging both economies.

The Democrats should also heed a lesson from history, and especially from Bill Clinton’s 1992 campaign. You don’t win elections by playing to your base and calling your would-be swing voters stupid or racist. You win elections by winning the argument on the economy, jobs, and health-care.

I don’t expect either side will take my advice, though!

Richard Nabavi