Dec 12, 2022

A Nearly Perfect Recession Indicator Flashes Red

Weekly Market Commentary

The Federal Reserve, interest rates, and inflation have been big topics this year. Chatter about a possible recession has been part of the conversation, too.

A few weeks ago, we looked at the enormous amount of stimulus cash that remains in savings, which is cash that could support spending and delay the start of a recession. It’s an analysis that went against the grain of the consensus. But the stash of cash could eventually dry up.

Let’s look at one indicator that has a nearly perfect record of forecasting recessions.

An inversion of the 10-year Treasury yield and the 3-month T-bill foreshadowed eight of the last nine recessions.

We must travel all the way back to 1966, when an inversion presaged a sharp slowdown in economic growth, but a recession did not ensue.

What is an inverted yield curve? An inversion occurs when longer-dated maturities yield less than shorter-dated maturities. Today, the 10-year Treasury yields less than the 3-month T-bill, as highlighted above in the table of returns.

It doesn’t happen often (recessions don’t happen often), but it suggests that investors believe short-term rates are headed lower. Maybe not today, but weaker economic conditions would be expected to force the Fed to cut rates.

When that has happened in the past, short yields fall faster than longer yields, and the curve normalizes. Note the graphic below. It illustrates the predictive ability of the yield curve.

While it has been a reliable predictor, it has not done a good job of pinpointing the start of a recession.

An inversion occurred anywhere from 5 months to 16 months prior to the onset of a recession (the 1973-75 and 2008-09 recessions, respectively). The average time span between an inversion and the start of a recession is 10 months.

There were no instances of a recession occurring without a yield curve inversion. The curve inverted in October.

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