Saturday, February 5, 2022

A Recession Indicator

At the beginning of the pandemic, our portfolio models were more conservatively positioned than they typically would be. I do not have a crystal ball and could not have predicted a global pandemic, but the bond yield curve inverted on August 26, 2019, signaling an increased risk of recession in the coming year. In response to the weakening economic conditions, I reduced portfolio risk and wrote several client emails outlining the concerns and the steps I was taking. Already being on Recession Watch, I probably reacted more quickly to the new health risk than I would have during other periods of the economic cycle.

  • We probably would have entered a recession in 2020 or 2021 even if the pandemic hadn't happened.

One of the most reliable indicators of a coming recession is an inversion of the bond yield curve as measured by the relationship between the yield on the Ten-Year and Two-Year Treasury Notes. Since 1955 an inversion of the yield curve has preceded all US recessions by 6 to 24 months. We are seeing some signs that the yield curve is flattening. Actions by the Federal Reserve and economic uncertainties could lead to a yield curve inversion and a subsequent recession. If this occurred, I estimate a recession would be a 2023 or 2024 event. There is nothing to do now but be aware of it and watch the data.

So, what does it mean to invert the yield curve? If we compare mortgage terms, we expect that the longer the mortgage term, the higher the interest rate should be. We expect to pay a higher rate for a 30-year mortgage than a 15-year mortgage. Likewise, investors expect to receive a greater yield on a ten-year investment than a two-year investment such as Treasury Notes. An inversion of the yield curve occurs when the current yield on the longer-term Ten-Year Treasury Note is less than the yield on the shorter-term Two-Year Treasury Note.

Two forces can work independently or together to cause a yield curve inversion. The first force is the Federal Reserve. The economy can accelerate too rapidly during an economic expansion and create inflation. The Federal Reserve may use monetary policy to curb inflation by raising short-term interest rates, causing shorter-term bond yields to rise. An inversion may occur if yields on longer-term bonds don't rise at the same rate.

The second force is investors. During periods of economic uncertainty, investors may choose to reduce their portfolio risk by increasing their allocation to fixed-income investments like bonds. A general allocation to intermediate-term bonds will include Ten-Year Treasury Notes. As demand for Ten-Year Treasury Notes rises, the yield on these bonds begins to fall. An inversion may occur if the Federal Reserve doesn't respond quickly enough to falling intermediate-term bond yields by lowering short-term interest rates or otherwise making monetary policy more accommodative.

The long-term average yield spread between the ten-year Treasury Note and the two-year Treasury Note is 0.93%. As of February 5, 2022, the spread is 0.62%, below the longer-term average but not yet close to inversion. 

Most conditions that lead to a recession and significant equity market drawdowns develop over time. The US economy is like a big ship, and it doesn't turn quickly. Wars and global pandemics that bring the global economy to a sudden stop would be exceptions. Suppose the yield curve inverts or the economy weakens significantly. In that case, I will move to a more neutral position, understanding that more conservative allocations might be appropriate within six to twelve months. The strategy remains the same. Watch the economic and market data and adjust portfolios as necessary.