The optimist's yield curve

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The optimist's yield curve

Clear arguments can be made that this is a late point in the US business cycle, but can the current economic expansion last? In a worst-case scenario, the US business cycle would stumble to an immediate close perhaps because of an Iran-induced oil shock, a further bout of tariffs, or simply a drum-tight economy coming up against its limit.

But how else might the US cycle play out? The possibility of an optimistic scenario where the current economic expansion lasts for years to come has not received the attention it deserves.

Let us flesh it out. There are a number of arguments that support a longer expansion. Firstly, the significance of the relatively recent inverted yield curve, which has predicted US recessions for several decades, is subject to some dispute. The 2-year to 10-year spread has not yet inverted and the absence of a term premium in the bond market muddies the interpretation of the inverted 3-month to 10-year spread, and it is notable that the measure provided a false signal in 1998.

Secondly, in a globalised world with an ageing population and rapid technological change, the structural downward pressures on inflation are intense. To the extent that inflation usually rises to problematically high levels at the end of the business cycle, contributing to the economy's eventual decline, that threat seems unusually small this cycle.

A variety of special factors have already helped to stretch out the current expansion. For example, expansions usually last longer after a financial crisis and when growth is unusually sluggish - both are relevant today. Equally, an expanded social safety net of improved financial regulations, the professionalisation of central banks, an increased adherence to Keynesian fiscal policies (relative to a century ago), and the rising service-sector share of GDP should all theoretically help to smooth the economic trajectory.

With the US Federal Reserve now on a rate-cutting trajectory, it is entirely reasonable to make the claim that more stimulative monetary policy should translate into more economic growth, that additional growth should reduce the risk of recession, and that a diminished recession risk should lengthen the business cycle. Of course, to play devil's advocate, one could just as easily argue that rate cuts might bring the cycle to a premature close since more growth overheats the economy, lowering unemployment, increasing inflation and triggering the cycle's end. It ultimately comes down to whether the additional growth from rate cuts translates into demand-side or supply-side growth.

It is possible that the US economy is not quite as tight as it currently looks. This argues for more tolerance before the economy overheats. While the unemployment rate is just 3.7%, this exaggerates the tightness of the labour market due to a low labour force participation rate.

Finally, while recessions can simply happen because growth has overextended itself, there is frequently a catalyst of some sort involved. The prior cycle was brought to a close by a housing bubble that ignited a debt crisis. The cycle before that ended in large part because of a tech stock bubble. The current expansion is hardly without vulnerabilities - leveraged loans are a prominent risk - but the magnitude of these risks seems smaller.

The bottom line is that there are a variety of coherent arguments that support the current economic expansion continuing for several additional years. This is not our base-case forecast, but it needs to be acknowledged. It represents one reason among many why abandoning risk assets altogether could prove unwise.

Eric Lascelles is chief economist at RBC GAM