What Is The Yield Curve? Why Is It Important? 8
The second reason the yield curve can’t really tell us the depth of a future recession is because of external shocks.
For some reason, or just out of randomness, large negative shocks tend to materialize when global economic conditions take a turn for the worse.
As Shakespeare so succinctly put it,
When sorrows come, they come not single spies. But in battalions!William Shakespeare, Hamlet
In terms of economies both domestic and international, Shakespeare’s battalions take the form of natural disasters and/or man made disasters occurring at the worst possible time. Examples of this include the Dust Bowl during the Great Depression, COVID sweeping across the globe in 2020, and Russia’s invasion of Ukraine in 2022.
Exogenous events like these can make recessions worse in a variety of ways.
In the case of natural and man made disasters (war), property is destroyed and jobs (as well as lives) are lost. If the disaster is large-scale enough, like the Dust Bowl, entire regions can be put out of work having lost their livelihoods.
The loss of the region’s production reduces its supply in domestic, if not global, markets. This second order effect drives up prices, giving rise to inflation during a time where people are struggling to find, if not losing, jobs.
The result? Even more economic pain and a deeper, more prolonged recession.
The same applies to war, where the entire economic output of a country can plummet overnight, taking many years to recover. As the world is discovering right now, the more important a country’s role in supplying today’s highly globalized markets, the more everyone else feels the pain.
As the supply of food and raw materials has become increasingly disrupted by Russia’s invasion of Ukraine, prices of food, energy, and raw materials have soared.
Higher prices for consumers, and costs for businesses, is the last thing the global economy needs when the yield curve is signaling tightening monetary conditions.
Simply because in a “normal” recession, the businesses that suffer the most are those which are over indebted, have poor or non-existent cash buffers, or fail to manage their costs properly.
In other words, they are the weakest companies, or companies with the weakest business models, in the economy. When a recession rolls along and they fail to raise money in a timely manner, these companies quite naturally go bankrupt.
Call it the Law of the Jungle or Creative Destruction, it’s just how things work in modern economies.
Now, when an exogenous shock coincides with a recession, the lost jobs and livelihoods further reduce business and consumer spending, which were already tumbling.
This fall in economy-wide demand sucks the companies that wouldn’t “normally” be considered weak into the desperate scramble for capital, even as banks are cutting back on lending.
The same thing happens when the exogenous shock leads to higher prices. Businesses which had managed their costs well suddenly find themselves having to deal with a spike in costs that wasn’t foreseen, much less planned for.
This spike in costs, together with lower levels of demand in the economy, erode their margins. They end up having to raise new capital in an environment where few banks and investors want to take on risk, and many end up going bankrupt.
While such businesses and their employees might feel aggrieved, as they would not have gone down in a “normal” recession, we live in a Pareto World. Fat tailed black swan events happen more often than we think, or like.
Ultimately, the yield curve cannot predict such exogenous shocks, or the efficacy of governmental intervention.
All it can tell us is that something is wrong in the economy, as reflected by the demand for money outstripping banks’ willingness to supply it.
To be continued…
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