The Recession Predictor You Should Really Listen To

There’s no question we’re living through some uncertain times

Inflation is on the rise and expectations (both mine and, according to the NY Fed, the general public) are that it’s going to stay high for a while.

But there’s another investor class that’s voicing its expectations. 

The bond market.

And you, as an investor, really need to pay attention to what it’s saying.  

Why Listen to the Bond Market Anyway?

Bond traders are typically more interested in the condition of the economy because bonds are directly linked to interest rates. And, putting aside the last 15 years of the Fed artificially squashing them, interest rates are tightly linked to the health of an economy. 

Now that the Fed is promising to normalize its once strained relationship with the market, interest rates are starting to have their say.

I’ve written about the concept of the yield curve and why it’s such an important tool, on a number of occasions.

You can read them here, here, and here.

But to quickly summarize, the yield curve represents the spread or the difference between long and short term interest rates. Longer term rates are typically more closely tied to economic expectations — things like inflation.

Shorter term rates tend to trend with monetary policy. 

Why is the yield curve such a great predictive tool?

When you gamble at most tables in Las Vegas, it’s you against the house and the odds are pretty much fixed, ever so slightly, against you.

But… head to Churchill Downs or any other racetrack, and it’s a different type of betting. “Parimutuel” betting is you betting against the other bettors in the race. The odds of the horses will move up and down depending on how much money is bet on any horse relative to the total money in the pool. By watching the odds move as you get closer to post time, you can effectively get an idea of which horse the “smart money” likes.

The yield curve gives you the same basic insight.

When you look at the yield curve, you’re looking at the expectations of the entire market. These folks are putting their money where their mouths are. 

So What’s It Expecting?

In December last year I warned about a looming policy error on the part of the Fed. In that letter, I noted that the curve (represented by the 10-year–2-year Treasury Note spread) had begun to flatten substantially.

Source: The Federal Reserve Bank of St. Louis

A flattening curve basically signals that the bond market is expecting bad times ahead — by suggesting that longer term rates are going to need to be more accommodating. In other words, a recession is likely coming. 

These events are usually confirmed when the 10-2 yield curve goes negative.

Well the curve has finally flipped…

Source: The Federal Reserve Bank of St. Louis

And what’s the confidence factor of the 10-2 yield curve as a tool for predicting recessions? 

I think this picture says it all…

Source: The Federal Reserve Bank of St. Louis

Make the trend your friend,

Bob Byrne
Editor, Streetlight Daily