This time is different: Why the breach of the Sahm rule doesn't mean the U.S. is in recession

The Sahm recession indicator (the Sahm rule), one of the most accurate leading indicators of every U.S. recession since the early 1970s, had already been trending in recent months and became a market focus after the most recent non-farm payrolls data release. While breaching the Sahm rule, based on history, can be interpreted to mean that the U.S. economy is nearing or already entered recession, the T. Rowe Price Fixed Income Division thinks this time is different. Here’s why. 

What is the Sahm rule?

The Sahm recession indicator signals the start of a recession when the three-month moving average of the national unemployment rate (UR) rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months. 

The details of the July breach tell a different story

While this value of 50 basis points (bps) was met with the July data when the UR rose to 4.3%, there are some reasons that support that this may not mean that the U.S. is entering or has entered recession, such as:

• The details of the July labor report suggest that the labor market is not as soft as suggested by the headline numbers. In particular, the UR increase was mainly driven by a rise in labor force participation, an increase in the number of people that were not able to work due to bad weather, and rising temporary lay-offs, with the caveat that those individuals could be called back into work over the next few months. Permanent layoffs, meanwhile, remained modest. 
• Importantly, the National Bureau of Economic Research (NBER) is the final arbiter on whether the U.S. economy has entered an economic recession. The NBER evaluates a range of indicators including real disposable income growth, real consumer spending, industrial production, and the unemployment rate, which all moved in the same direction prior to the last three recessions that occurred after a triggering of the Sahm rule. In contrast to this historical analysis, during the past three months, only household employment data have been soft, while the other indicators remained expansionary. 

While this time may be different for a breach of the Sahm rule, it didn’t prevent markets from fiercely overreacting, in our view, when this negative data point for the world’s primary economy almost immediately followed the Bank of Japan’s historic 25 bps policy hike on July 31. As a result, August’s generally illiquid summer market had to immediately grapple with the synchronous prospect of higher policy rates in Japan and potentially sharply lower policy rates in the U.S. (materially driving both currencies forcefully in different directions), which, in combination, represented a form of a margin call for a yen carry trade that had grown in seismic scale since the end of 2022. Interestingly, while this global capital market tumult followed the triggering of the Sahm rule, when much of the yen carry trade quickly unwound, capital markets have not only largely stabilized but also have mostly recovered what was lost during this recent market shock.

Fed rate cuts could lend support 

Beyond the Sahm rule, we also recognize that recent decelerating trends in inflation and employment growth have also opened the door for the Fed to start easing monetary policy (helping extend the economic cycle), but just not at as fast a pace as the market quickly priced, which was part of the phenomenon that sparked the global carry trade unwind referenced above. T. Rowe Price’s Chief U.S. Economist Blerina Uruci currently expects up to three rate cuts from the Fed before year-end if inflation and labor markets continue to cool. To the extent that this view matches prospective Fed action, the current state of the economy and markets appear to be in a mid-cycle adjustment where the Fed may cut rates in 25 bps point increments four to five times in aggregate (including the three rate cuts mentioned above). Such a move would help extend the fundamentally sound condition of the U.S. economy, which remains resilient in our view.

Bottom line 

While the technical catalysts that drove the sharp capital market unrest described above look to have now largely played themselves out, additional volatility, driven by other considerations such as geopolitical and U.S. election uncertainty appears likely for this fall. There is a silver lining, however, as increased volatility helps make a case for active management in fixed income from the following three perspectives:

• A normalizing U.S. Treasury yield curve – While the normal shape of the U.S. Treasury yield curve is upward sloping as it appropriately discounts the time value of money, the U.S. Treasury yield curve has been far from normal and inverted since July of 2022. With the Fed now in play for September and driving yields down in the front end of the Treasury yield curve in the process, “curve steepening” strategies represent an opportunity for active fixed income managers to position ahead of a return to a normally shaped U.S. Treasury yield curve. 
  
• A resilient U.S. economy is supportive of credit – While spreads remain historically tight across the quality spectrum, credit fundamentals that have been sound appear poised to remain so in our view. More importantly, credit markets remained open during the recent market distress, which signals a diminished probability that hidden technical pressures exist across global credit markets.
  
• U.S. Treasury yields plunged during last week’s market upheaval – Increased market volatility and dramatic swings in U.S. Treasury yields can create opportunities for fixed income managers who can tactically adjust duration exposures. T. Rowe Price Fixed Income Teams took the opportunity to shorten duration in select strategies when the 10-year U.S. Treasury yield overshot (in our view) downward to the 3.7% range—now closer to 3.9% as of August 12—particularly relative to heavy U.S. Treasury supply still to come. 
  

From a more holistic perspective, meanwhile, the move out of cash and into short duration—the T. Rowe Price team has been presciently long duration within the front end of the yield curve— now warrants additional consideration with the next Fed communications coming in the form of a “live” September meeting. Beyond a small step into short duration, the next larger move into intermediate/core fixed (as well as global fixed income) becomes a light at the end of the tunnel that suddenly approaches with a now quickly normalizing Treasury yield curve. 

Through a disciplined investment process in conjunction with expanding quantitative capabilities and its ongoing global bottom-up research effort, the T. Rowe Price Fixed Income Division is qualified to actively manage through an investment environment that looks to be volatile in the weeks and months ahead.