A Little-Known But Powerful Recession Indicator Flashes Red

A Little-Known But Powerful Recession Indicator Flashes Red

While last week’s consumer inflation (CPI) reading may have opened the window to avoid recession, it may be too little too late, as a little-known but mighty started flashing red last week. The 10-year Treasury minus the 2-year yield is probably the best-known recession predictor, and it turned red in April. Historically, when the 10-year US Treasury yield falls below the 2-year yield, also known as a yield curve inversion, a recession is looming. Since the 1970s, an inversion of the yield curve has occurred before all recession. The only stain on its balance sheet is the 1998 inversion which produced no subsequent economic downturn. Unfortunately, even when the signal is correct, it usually occurs about a year and a half before the start of a recession, so it is not conducive to timing a recession. Also, the stock market tends to rise in the mid-teens percent and sometimes higher after the reversal.

In 2018, the Fed published a lesser-known but more robust predictor of an impending recession. The indicator is called “short-term forward spread”. It measures the expected yield on the three-month Treasury eighteen months in the future minus the current three-month Treasury rate. While it may sound complicated, the short-term spread reflects bond market expectations for Fed rate changes over the next year and a half.

While the 10-year minus 2-year yield curve has been inverted for some time, the short-term spread just inverted and produced its recession warning last week. When the short-term term spread is negative, the market is pricing in Fed rate hikes over the next year and a half, and a recession is likely. Moreover, a study by the Fed has shown that this measure is also useful in predicting future economic growth.

Like the yield curve, an inversion in short-term forward spreads has preceded every recession since 1973. Again, like the yield curve, the forward spread predicted a coming recession in 1998 that did not is never materialized. The futures spread provided a more timely indicator of the potential economic downturn and stock market peak than the yield curve. It usually reverses about a year before the recession and has reversed between 18 and 2 months before previous recessions.

Additionally, a previously mentioned Fed study also showed that this metric helps predict future stock returns. It should be noted that typical stock declines of more than 20% following a signal from the short-term gap were only for the eight occurrences since 1973. Several other historical indicators, from performance after the elections of midterm to historical performance after a more than 20% market decline, provide more optimistic assessments of forward yields.

With the stock market at nearly 12% from its low, this recession warning is probably the perfect time to confirm your risk tolerance and rebalance portfolios if necessary. While it remains wise and prudent to remain optimistic about equity returns over the long term, the short-term trajectory is unknown and much remains to be done to control inflation. Given recession expectations, investors should hold onto enough low-risk assets, such as cash and high-quality bonds, to cover their living expenses in the event of an economic downturn. Upgrading equity portfolios to high-quality, dividend-growing stocks will likely prove wise. This quality, valuation and focus on dividends should allow investors to stay invested with less anxiety during economic downturns, which has always been the secret to long-term success.

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