Recession may be around corner in 2020

Maybe the best reason to think there won’t be a recession in 2020 is that so many people are saying there will be.

The idea being that the more people are worried about something, the more they should do to try to avoid it — right? You’d certainly think so, but not always. Consider the housing bubble: Economists including Paul Krugman and the Center for Economic and Policy Research’s Dean Baker spent years warning about the impending danger, but it didn’t matter. Policymakers didn’t do anything, and everyone else was too busy trying to get in while the getting was good to concern themselves with whether it was sustainable or not.

Which brings us to one of our biggest risks today. Interest rates, though still low by pre-crisis standards, are starting to get a little high by our post-crisis ones. The best recession predictor we have — the difference between the government’s 10-year and two-year borrowing costs — is beginning to flash yellow.

Why does that tell us so much? Well, it has to do with the economic story that’s embedded within longer- term interest rates. Those, you see, show us what markets think shortterm interest rates are going to average over that time, plus a little extra to make up for the risk that inflation ends up being higher than people thought it would. So when long-term rates are lower than short-term ones, what’s known as an “inverted yield curve,” it’s telling us that markets think the Federal Reserve is going to have to stop raising rates and start cutting them in the near future. And when would it do that? When it’s trying to fight a recession.

The good news is that this hasn’t actually happened yet, but the bad news is it probably won’t be long until it does. Not when 10-year interest rates are a mere 0.25 percentage points above two-year ones. All it should take is another rate hike or two for it to invert, at which point, if history is any guide, we could expect a recession within the next year or so. Right around 2020.

So far, so normal. Higher borrowing costs are always a threat to the economy. They slow the housing market, which usually slows consumer spending as well, and, as a result, hurts profits enough that companies either slow their hiring or maybe start layoffs. What makes them an even bigger threat right now, though, is the other problem that’s pretty plain to see: all the money that companies have borrowed over the past 10 years.

Indeed, as Bloomberg Opinion’s Noah Smith points out, nonfinancial corporate debt has just hit an all-time high as a share of the economy. And, as you’d expect when so many loans are being made so quickly, a lot of it looks quite risky. Companies that already have a lot of debt have been some of the biggest borrowers recently — the $1.3 trillion “leveraged loan” market. But, despite that, there’s been so much competition among lenders to make these loans that they haven’t been requiring a lot of protection for themselves if things go bad.

In a certain foreboding sense, that’s understandable. That’s because they aren’t holding onto these loans themselves but are rather bundling them together into securities known as “collateralized loan obligations” to sell to investors. That lets them turn a big chunk of their BBB-rated corporate loans into AAA-rated bonds. Any single borrower might default, but the chance that most of them would at the same time should be negligible.

All of this should sound uncomfortably familiar. After all, replace “businesses” with “households,” and you’d have a pretty good description of what went wrong in 2008.

Now, that’s not to say that this will end as badly as things did in 2008, but it’s not exactly the highest of bars to say that we’ll avoid a repeat of the worst financial crisis in history. What we can say is that companies will probably face higher debt payments right when they’re dealing with lower profits — that is, when interest rates really are getting high — to the point that a few might end up defaulting. How bad would that be? That’s hard to say. But at a minimum, these kind of corporate defaults would probably be enough to send an economy whose virtuous circle was looking a little wobbly into a vicious one instead.