Yield Spread Sends "Recession Warning"

Authored by Jesse Colombo via RealInvestmentAdvice.com,

A few weeks ago, I wrote a piece in which I estimated when the next U.S. recession and bear market would start based upon where we were in the current yield curve cycle and comparing it to the prior six economic cycles. According to that admittedly simple exercise (it wasn’t a hard prediction, but just an estimate based on history), the next stock market peak would occur in September 2019 and the recession would start in February 2020.

In today’s piece, I wanted to discuss in further detail an important chart that I included in my “When Is The Next Recession And Bear Market” piece: the 10-Year/2-Year U.S. Treasury yield spread. I’ll start with a brief refresher: in a normal market, and assuming that the bonds are of the same credit rating, longer-term bond yields are higher than short-term bond yields to compensate investors for the greater risk of holding during a longer period of time (default and inflation risk).

A steep or “normal” yield curve is typically seen early on in the economic cycle and lasts for the majority of the cycle and can be thought of as a “green light” for investors. As the economic cycle matures, the yield curve takes on a flat shape. A flat yield curve can be thought of as a “yellow light” for investors. In the very final stages of an economic cycle, the yield curve often inverts as the Fed’s aggressive rate hikes causes short-term interest rates to actually rise above longer-term interest rates. An inverted yield curve can be thought of as a “red light” for investors.

The 10-Year/2-Year U.S. Treasury bond spread is a very simple, yet powerful, way of visualizing the U.S. Treasury yield curve. To create this chart, the current two-year Treasury note yield is subtracted from the current ten-year Treasury note yield and plotted over time. When the spread is over 100 basis points or 1 percent, it is consider to be a normal or steep yield curve. When the spread is between 0 percent and 1 percent, it is equivalent to a flat yield curve, which is the “recession warning zone” because it signifies that the economic cycle is becoming long in the tooth and that a recession is likely to occur within a few years. When the spread goes under 0 percent into negative territory, that’s when the yield curve is inverted, which implies that a recession is imminent. According to the 10-Year/2-Year U.S. Treasury bond spread, we are currently in the “recession warning zone,” but not the “recession zone” just yet.

The yield curve inverted before every U.S. recession in the past half-century, which is why it is worth paying close attention to (on the chart above, the gray zones show when historic recessions have occurred). In recent years, many bullish market commentators have promoted theories supposedly explaining why inverted yield curves are obsolete as a recession predictor, why “this time is different,” and so on, but a brand new San Francisco Fed paper confirmed that the yield curve is still the most accurate predictor of U.S. recessions.

Why do inverted yield curves predict economic recessions? The main reason is because banks borrow at lower, short-term interest rates and lend money out at higher, longer-term interest rates, and the differential or “spread” between the two rates is where they earn their profit. In addition, yield curve inversions typically occur after several years of interest rate hikes, which have a dampening effect on the economy and financial markets. As fund manager Jeffrey Gundlach has said, the Fed has usually raised interest rates “until something breaks.” My major concern is that it will be the extremely dangerous “Everything Bubble” that breaks this time around.

Comments

bshirley1968 FreeShitter Wed, 03/07/2018 - 08:36 Permalink

Really what the writer is telling us is that the only "recession" that matters now are "financial institution" recessions.

The real, objective, produce-real-products-economy has been in recession/depression for a decade, but as long as banksters can borrow on the short end, loan on the long end, and make a decent spread, then all is well?

THAT in a nutshell tells you everything wrong with our "economy". The parasites have taken over the host and are draining it dry. Financial economy, debt economy, parasite economy, paper economy......all one and the same.

In reply to by FreeShitter

Iconoclast421 Wed, 03/07/2018 - 08:13 Permalink

Lets not get ahead of ourselves now... we're still 18 months away from that signal coming in, and then another 6-18 months from the actual recession start. That is 3 more years of pumping!

Chris88 Wed, 03/07/2018 - 08:25 Permalink

How could we possibly have a recession, ZH?  Leftist Donny is using taxpayer money to subsidize inefficiency - MAGA!  Surprised the cheerleaders even ran this article.

Kokulakai Wed, 03/07/2018 - 08:26 Permalink

The economy was gutted by a series of trade agreements.

The Fed has prepared the carcass by tossing fiat onto the dying embers of industry.

Will this time be different?

silverer Wed, 03/07/2018 - 08:28 Permalink

The US has a long way to go to hit bottom. Think Venezuela. The place sucks worse than you can imagine, but they're still handing people fake money to exchange for what they can find to keep themselves alive. Misery is extended by the government, as Maduro is a stubborn elitist ass and won't change his ways. Count on the US government, with the world's strongest military, to break records on keeping misery going once the SHTF in the US. Those in power will stay in power for as long as they possibly can, just like Maduro in Venezuela.

bshirley1968 silverer Wed, 03/07/2018 - 08:56 Permalink

It's not about how far we have to fall, it's about the speed of the fall.

I have never been to Venezuela but am guessing that when you get 50 miles outside of Caracas there isn't much by way of industrialized economy. That being said, the people in Caracas are the ones really suffering. That is where your comparison ends. Now imagine LA, San Francisco, Seattle, Portland, Vegas, Denver, Chicago, St. Louis, Dallas, San Antonio, Huston, Memphis, Atlanta, Philadelphia, NY, Boston, DC, Miami, Orlando, Tampa.....without any toilet paper or other basic necessities. DC will have a little more trouble maintaining order than the overblown mayor of Caracas.

In reply to by silverer

aliens is here Wed, 03/07/2018 - 09:08 Permalink

Didn't someone said something about a recession last year and the year before? I can't keep track of the contradicting articles on ZH anymore. Doom and gloom crowd are all over the place on doom.

dirty fingernails Wed, 03/07/2018 - 09:38 Permalink

Have they juiced and changed the metric enough to hide a recession with stock market propping and gov spending? Considering the numbers of store closings, factory orders dropping, price increases, etc and even with enormous amounts of gov spending we still hit a fake ass 2.1%.

 

I know that when it gets bad enough they can't hide it, but I'm sure they can obscure the leading edge which is where we are.