This Is the Key Recession Indicator to Watch

This fact will surprise no one, but the "yield curve" is supposed to be, ideally, curved. As it stands now, the curve looks dangerously close to inverting. Ten-year U.S. Treasury yields are supposed to be higher than two-year U.S. Treasury yields. There is supposed to be an explicit yield reward for agreeing to lend money for longer durations and forgo the plethora of investment opportunities that may pop up along the way.

Accounting for normal inflation concerns, a positive spread should exist between two-year and ten-year rates. When a yield curve inverts, meaning ten-year rates go below two-year rates, it usually represents pervasive pessimism and heralds a coming recession. There are a few other common recession indicators, such as the information found in Conference Boards' Leading Economic Indicators or a decrease in the copper to gold ratio, but these are not quite as reliable as the yield curve and do not give any interesting insight at the moment.

Historically, the difference between two-year and ten-year treasury yields ranges from 0 to 250 basis points. This means that a 20 basis point difference, as it was recently, is indeed quite low, but far from uncharted territory. Although this current yield spread may not be a sure sign of a recession, it is important to note that every time the yield curve fully inverts a recession has followed. Four times in the past 35 years, however, the yield curve has been at or near these low levels only to turn around with no recession.

I'm including, in that set, the moment in 1998 when the yield curve printed negative but quickly rejected and returned positive. For our purposes I'm only counting times where we invert for at least a full day. Three other times the yield curve has fully inverted and a recession did follow. The impending recession lasted between eight and 20 months.

Why is it important for us to know when the next recession is coming?

The answer to the first question is simple. Equity markets hate recessions. The general tendency is for stocks to head lower just prior to the onset of a recession and then bottom sometime during the recession usually closer to the end. The decline in the stock market tends to be proportional to the length and depth of the recession. The last two recessions have been characterized by the massive collapse of major asset bubbles with tech stocks in 2001 and then real estate in 2007. The obvious answer is that if we can accurately predict the coming of the next recession we can manage investment risk far more efficiently.

Is the yield curve giving us reliable intel?

There are two things to consider when trying to decode the yield curves current signal.

First, it has not inverted yet, it is just close to inverting. The axiom is very specific in saying in that an inverted yield curve signals a coming recession, but this is only if or when it inverts. Intuitively, we all understand that the curve must flatten before it inverts and that we have to pay attention as it gets close. We also know from history that the yield curve occasionally flattens and steepens and flirts with negativity, but many times does not actually commit to negativity. Traders are people of action, and we hate to sit and watch. I hate to be the bearer of bad news, but it's best to get comfortable with waiting because we might have to do it for a while longer.

Secondly, and most important, global central bank policy has probably distorted long-end rates enough to interfere with the historical predictive powers of the curve. The European Central Bank, Bank of Japan, and the U.S. Federal Reserve are ten years in to an unprecedented sovereign debt-buying spree that has left a huge amount of global debt with negative yields. As the Federal Reserve forces short-end rates upward, the normal knee-jerk reaction of long-end rates increasing has been interrupted by low foreign rates. In other words, our long-end rates are being held unusually low based on how attractive they are compared to, for example, the German ten-year yields currently trading at .37.

Bottom line: I am not concerned by the shape of the curve and there are too many positive things going on in the market to pull back and prepare for a recession.

Written by Jim Iuorio. Read more from the author here.

Read more stories like this on OpenMarkets. And for trader tools and resources visit: https://activetrader.cmegroup.com

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