Given that a growing number of economists and strategists are expecting a recession this year or next and that recessions are almost always officially recognized months after they start, what indicators should advisors be watching as early warning signs?
Here are some of the indicators that market strategists and economists are citing in their recent outlooks.
There are multiple warning signs that economists and strategists cite as key indicators of an upcoming recession but probably none as often as the inverted yield curve — when the short-term Treasury yield tops the long-term yield.
Once the yield curve inverts, recessions usually follow about 12 to 18 months later, though the time delay can be as short as six months and as long as 24 months, according to analysts.
“Each of the past nine recessions were preceded by a yield curve inversion,” according to Fitch Ratings, referring to the spread between the when the 10-year Treasury note and one-year Treasury bill.
Others reference the 2- and 10-year Treasury spread, but Cam Harvey, partner and senior advisor, Research Affiliates, and a finance professor at Duke University, says, “the crucial thing is to use a very short-term interest rate” in the calculation, such as the 3-month Treasury bill. “I get nervous when I see people talking about the 10-year minus the 2-year.”
The spread between the 3-month Treasury bill and 10-year Treasury note is close to flat, at about 28 basis points, with the 10-year yielding more than the T-bill. A year ago, the 10-year Treasury was yielding 100 basis points more than the 3-month bill.
The current narrower spread primarily reflects the increase in short-term rates as a result of Federal Reserve rate hikes. Long-term rates, too, have also risen but less than one-fifth as much as short-term rates, and the 10-year Treasury yield is now about 50 basis points below its recent 3.25% peak reached in October.
Economic Data — From the Fed
“Recession models can be categorized into two groups: those which use economic data and those which use financial market data,” according to Bank of America Merrill Lynch economists writing in the firm’s mid-November Economic Viewpoint report. The former focuses on the current economy; the latter on a more ‘forward-looking’ view, which includes the yield curve analysis.
Among the economic data models cited by the Merrill economists is the “smoothed recession probability” published by the Federal Reserve Bank of St. Louis. The data series consists of four economic indicators: nonfarm payrolls, industrial production, real personal income excluding transfer payments and real manufacturing and trade sales, and it is currently at its highest level since March 2016.
Economic Data — From NBER