Recession? Not yet.
There is a good chance the US Federal reserve will raise short term interest rates at their December meeting. The Fed typically raises short term rates to prevent inflation when the economy starts to overheat. The Fed typically lowers short term interest rates when the economy slows down to try and stimulate spending and get the economy going again.
While the Fed has control of short term interest rates, they do not have control of long term rates. Long term interest rates, like the 10 year treasury bond or the 30 year treasury bond are market driven. Historically, when the economy and stock market start doing poorly, it causes investors to flee from stocks for the perceived safety of bonds. As demand for bonds increases, bond prices also increase, which drives long term interest rates down.
Given these relationships, a fairly reliable predictor of an upcoming recession is when short term interest rates are actually higher than long term interest rates. This is known as an inverted yield curve.
Below, you see a graph of the 10 year treasury yield minus the 2 year treasury yield. When the 10 year minus the 2 year is negative the yield curve is inverted and a recession typically follows. You can see this in the chart as the blue line crosses below zero just prior to each of the last 5 recessions.
Recessions in the chart are depicted by the grey vertical bars. Note that lately, we have gone from over 2 on the chart, to less than 1. The good news is that the relationship is still positive, and this is a good sign that we are not currently headed for recession… yet.
The last two weeks have seen an increase in long term treasury yields, which also means we have seen bond prices, especially long term bond prices, falling. Some investors have been taking money out of bonds, and placing them in stocks. This is a signal our economy is strengthening further indicating there is no sign of an upcoming recession.
We know that recessions are not good for stocks. Bonds tend to do better during recessions due to their perceived safety. So what would happen, if we used this indicator to position more defensively prior to the next recession?
Starting with the earliest recession on the chart, here is how stocks, as measured by the S&P 500 performed from August 1978 through June 1980. This corresponds to the month that the yield curve inverted, until the time the recession ended. Though there were some precipitous drops in October 1978 and February 1980, the S&P 500 was actually higher over the entire time period.
Here you see a similar story from October 1980-November 1982. Again, stocks fell but finished higher between the time the yield curve inverted to the end of the recession.
December 1988- March 1991 is depicted below with stocks rising over much of the time period.
January 2000- October 2001. Here we see stocks clearly lower from the time the yield curve inverts to the end of the recession.
And of course, the great recession. The yield curve began to invert in February 2006, with the recession officially ending in May 2009.
So an inverted yield curve has been a reliable historical indicator of an upcoming recession. We do not have an inverted yield curve currently, and the last few weeks has seen the yield curve strengthen which has been good for stocks but bad for bonds.
Eventually we will see the yield curve invert and this could be a time to consider a more defensive portfolio, but as you can see, each recession has been a little different and this strategy does not always work.
Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. Past performance is not an indication or guarantee of future results