Why this economic cycle is defying history—and breaking the rules

The current cycle has defied history. It’s contradicting two important rules that economists typically expect the United States economy and markets to follow, and which they normally utilize in forecasting.

Here are the broken rules, and why it matters that the economy is charting a different course today.

Rule 1: An inverted yield curve predicts recession

Economists have long held that the shape of the yield curve serves as a predictor of recession. Prior to the COVID pandemic, the most reliable signal of impending recession was the inversion of the so-called near-term yield curve spread: Since 1961, when the yield on the 3-month Treasury bill exceeded the yield on the 3-month Treasury bill 18 months forward, a recession followed 100% of the time.

Across all cycles prior to the pandemic, when this spread inverted, a recession began 12–13 months later on average. It was considered an extremely reliable predictor.

However, that rule was broken in this cycle: The near-term spread first inverted in December 2022. Twenty-two months later, the economy is not in a recession, and we see limited signs that one is around the corner.

Rule 2: The Sahm rule on unemployment

Another recession-forecasting rule with a strong track record is the “Sahm rule,” named after economist Claudia Sahm. We expect this rule to be broken this cycle as well.

The Sahm rule tracks the unemployment rate, and states that if the three-month moving average of the U.S. unemployment rises more than 50 basis points from its low point over the last year, the U.S. economy is already in recession. In the current cycle, the unemployment rate troughed at 3.4% in April 2023. When it rose to 4.3% in July 2024, the Sahm rule was triggered for the first time in this cycle.¹

Historically speaking, this would indicate that a recession is getting underway. The Sahm rule, like the yield curve rule, was 100% accurate prior to the pandemic dating back to 1959.

We take the Sahm rule seriously, and see it as a clear sign that the labor market has weakened in 2024. On this basis, we recently raised our 12-month forward odds of recession to 25%, from 20%. Yet we still see a recession as unlikely, meaning the Sahm rule, too, is sending a false recession signal.

While the unemployment rate has increased, we point out that we have not seen an increase in the rate of people newly out of a job (related to layoffs) collecting unemployment insurance. This is measured by the so-called insured unemployment rate, derived from the weekly initial jobless claims data. In every prior cycle when the Sahm rule was triggered and a recession ensued, the insured unemployment rate was also rising—on average by 47 basis points (bps) year-over-year. By contrast, today, the insured unemployment rate hasn’t moved over the last year. It remains at a low level of 1.2%.

What’s causing this disconnect? Why do we believe the Sahm rule is incorrectly indicating a recession? Why are layoffs, a key mechanism of recession, so low?

We suspect the principal cause is the once-in-a-generation labor shortage of 2020–2022. As companies scrambled to find workers, they had to raise wages aggressively to attract them. It was a painful process, and we suspect companies today remain solidly in labor-hoarding mode as a result.

There’s plenty of evidence that hints at this in a variety of layoff-related data we consider:

• The layoff rate is still well below the pre-pandemic run-rate, according to the latest Bureau of Labor Statistics JOLTS data (Job Openings and Labor Turnover Survey).²
• Corporate commentary regarding layoffs on earnings calls has not reported widespread current or imminent layoffs.
• The Challenger, Grey & Christmas survey on announced job cuts by companies is consistent with low levels of layoffs.
• State-level data collected pursuant to the WARN Act (the Worker Adjustment and Retraining Notification Act), which aggregates impending layoffs, isn’t indicating increased job cuts.

Another reason to think this is the case: Over the last year, permanent layoffs have accounted for about 40% of the increase in U.S. unemployment. Across past cycles, at the start of each recession, permanent layoffs were responsible for 80% of the increase in unemployment on average.³

What explains rising unemployment? Surging labor supply

So if layoffs, potential key drivers of recession, aren’t the main force pushing the unemployment rate higher, what is? The answer is surging labor supply caused in large part by a rapid increase in immigration.

The Congressional Budget Office has estimated that net immigration has risen from a prior five-year average pace of 110,000 per year in 2021 to 2.4 million in 2023 and in 2024. This wave of immigration, 20 times the previous rate, has likely increased the unemployment rate by 10 bps to 15 bps, as new entrants into the labor force tend to show up as unemployed first before they eventually find jobs. Without this surge in immigration, it’s unlikely the Sahm rule would be giving a recession signal today.

Rising unemployment, in the aggregate, seems due more to an influx of people into the labor force looking for work rather than rapidly deteriorating labor demand. To be sure, labor demand has weakened, but it has weakened in a gradual and linear way, as opposed to a rapid and nonlinear change—which is what a recession is all about.

Why layoffs—not just unemployment—are so dangerous

Layoffs pose a threat to the U.S. economic cycle because they produce a feedback effect: Layoffs constrain consumer spending and hurt companies, which, in turn, sparks more layoffs.

While recession dynamics can be different in other economies,⁴ the U.S. economy is largely closed and consumer-based, as consumer spending accounts for nearly 70% of GDP. Once layoffs begin to inflict damage, the feedback effect on consumer spending is very hard to halt or reverse (for the Federal Reserve, that is). The end game has historically tended to be a collapse in consumer spending; the chart below shows 2008–2009, which was an extreme example.⁵

We see favorable leading signals on layoffs

Layoffs are not surging; indeed, they are low. Yet not everyone is sanguine on the subject. One counterargument we have heard is that layoffs are a lagging indicator, and if policymakers and investors wait to see an increase in layoffs, it will be too late to change course. Recession dynamics would already be underway.

We strongly agree that once layoffs rise rapidly, a recession would be essentially unavoidable. But not only are layoffs currently low, several reliable leading indicators of layoffs are showing no sign that a macro layoff cycle is just around the corner:

• Corporate sentiment on the overall economy has improved over the last year, as inflation has generally come down faster than expected—paving the way for rate cuts from the Fed.
• Corporate profit margins remain healthy and not consistent with a layoff cycle being imminent.
• Even though the demand for labor has weakened, the outright level of demand, measured by job openings, remains solid, consistent with the levels seen in 2018/2019 or slightly below those levels.

Still, we remain attentive to the risks. Sentiment can be fickle. If corporate sentiment turns in a dour direction in the coming months, a layoff cycle would be more likely. However, the Fed plays an important role in staving off this dynamic: The Fed has now communicated a faster pace of rate cuts, which should be enough to prevent an abrupt tightening of financial conditions and a souring of corporate sentiment, in our view.

Here’s what we expect following the recent softer employment data: A faster pace of rate cuts from the Fed, with 100 basis points of cuts this year (versus just one 25 basis point cut penciled in prior to the July jobs print). Importantly, the recent inflation data has come in soft (with core PCE advancing by less than 2% annualized over the last three months), which opens the door to these faster rate cuts. We also expect the Fed to cut an additional 100 basis points in 2025 to bring the policy rate down to a range of 3.25-3.5% by the end of the year.

Investment implications: Opportunities

We see two important implications for investors:

Potentially attractive prices: We continue to hold the view that when market participants become overly concerned about recession risk, this is likely to be an attractive buying opportunity. That dynamic could emerge again in the near future, with two highly trusted “rules” pointing to a recession.

We still think the current economic cycle has years of steam left, barring an unexpected exogenous shock. Some investors have expressed concerns that geopolitical events could deliver such a shock. But as we’ve written, according to our analysis of 80 years of data, geopolitical events usually have no lasting impact on large-cap equity returns and can, in principle, potentially be hedged appropriately in portfolios.

An exception was the oil shock during the Middle East crisis of 1973. Unlike today, however, at that time, the United States was highly dependent on imported oil. Today, geopolitical events are likely to have local, rather than global, impacts, and the effects will often be felt fleetingly.

A return to negative correlation: Finally, a positive feature of the recent market volatility is that it is bringing back the inverse relationship between stock and bond prices, a favorable investing dynamic for diversification and hedging purposes. Since the COVID shock of 2020, positive correlation between stock and bond prices has prevailed—that is, stocks and bonds have moved in the same direction. As 2022 illustrated, this can be especially distressing when stocks and bonds sell off at the same time.

Early in 2024, we forecasted that the more traditional, and favorably negative, stock-bond correlation would reassert itself. That’s a big positive for multi-asset portfolio diversification.

During the recent spike in equity market volatility in late July/early August, the correlation between stocks and bonds switched decisively into negative territory. It’s too early to say the inverse relationship is back in play structurally to the degree that persisted prior to the pandemic; nevertheless, the recent price action has made us more confident in the diversification enhancement properties of bonds.

We remain vigilant about potential risks. But today’s combination of easing inflation, low layoff rates, supportive corporate sentiment and robust investing opportunities makes the current situation—perhaps counterintuitively, given some alarming headlines and dramatic market volatility—a more positive story than it may seem.

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Your J.P. Morgan team can help you understand the latest developments in the economy, and what they mean for your finances and investment portfolio.

¹ In the most recent labor report, for August, the unemployment rate ticked back down a tenth to 4.2%.

² The layoff rate derived from the Current Population Survey is also low, though not quite as low and downward trending as the JOLTS layoff rate. Amanda Michaud, Economist at the Federal Reserve Bank of Minneapolis, is usefully publishing the CPS layoff rate on a monthly basis, see: https://sites.google.com/qlmonthly.com/home/data.

³ Temporary layoffs are excluded in our aggregation of these data.

⁴ For example, terms-of-trade shocks involving large fluctuations in export and/or import prices can be important causes of recession in smaller, more-open economies.

⁵ Declines in household wealth will also play a role in the feedback effect of spiraling layoffs on consumer spending, as once this dynamic typically gets going, it usually results in declines in asset values (e.g., stocks and housing), which in turn makes consumers even more cautious, forcing them to save more and spend less. Furthermore, recent research has shown that U.S. recessions tend to fall harder on “non-essential” industries, which comprise a higher share of lower-income workers, which helps explain why income and wage inequality tend to rise in recessions. See: https://conference.nber.org/conf_papers/f202255.pdf.