The Yield Curve

What the bond markets are predicting is that the next recession is already set in place from a long period of inflation and the distortion of global interest rates for far too long. With a record deficit combined with rising rates the U.S. government will not have the same ammunition to attack the powerful forces of economics that struck in 2008. Economics will strike again. Bubbles can last longer than expected, but when debt is run-up, money is printed without concern for its effects and debt is assumed in excess, bubbles form. 

But they eventually pop.

Today we are living way beyond our means. The only way to determine the timing of the end is by researching prior cycles. Increasing rates are the first sign, but it does not necessarily act like a pinprick to an oxygen filled balloon. Since most reasonable analysts agree that our first premise is accurate, in that we have had years of excess artificially induced growth, let's focus on the very difficult to determine question of timing. The phrase "economic indicator" should be reserved for economists. We want to understand real stock market indicators. What are the signs that the stock market cycle is ready to turn from a bull into a bear? 

The Yield Curve

When the economy is healthy, longer dated bonds demand a premium return. Investors naturally demand more money to compensate the extra time, risk and inflationary impact involved in having their capital tied up for a longer period of time. The yield curve notes the difference between the 10-year and 2-year yield on U.S. government bonds. This has been a reliable accurate signal for a looming recession over history. Inverted yield-curves are when the yield on 2-year bonds exceeds that on 10-year bonds which is a counter-intuitive situation. Normally if an investor locks her capital up for a longer period of time, that should be compensated for with a higher yield. But when the short term yield is larger than long dated bonds, that suggests that the credit market is forecasting a "top" nearing. 

Recently the spread between the 10-year government bond and the 2-year bond has shrunk, suggesting traders are concerned about growth. Grey areas below are U.S. recessions, you can see that the yield spread has dipped below zero before each one. 

After careful analysis of this chart one can see that when the spread shrinks towards the horizontal black line where investors demand the same return for 2-year and 10-year government bonds, a recession follows, but not always immediately. In both 1984 and 1994 the recession hit a few years after the signal was triggered.

Every recession over the past 60 years was preceded by an inverted yield curve according to research from the San Francisco Fed. Inversions correctly signaled all nine recessions since 1955 and had only one false positive in the mid-1960s but that period witnessed a true economic slowdown even though it did not reach the status of an official recession. Keep an eye on the spread. The chart is updated and can be viewed here:

https://fred.stlouisfed.org/series/T10Y2Y

Dan Shainberg

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#RecessionResister
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