This Trusted Gauge Says The Recession Is Knocking At Our Door

This Trusted Gauge Says The Recession Is Knocking At Our Door
Stéphane Renevier, CFA

11 months ago2 mins

While the deep inversion of the yield curve sends a clear warning that a recession is on the way (and the yield curve is never wrong), it doesn’t say much about when it’ll arrive. For that, you want to look at the yield curve's post-inversion behavior: and what it’s saying right now is that a recession might already be knocking on our door.

Typically, short-dated Treasury bonds carry a smaller yield than longer-dated bonds, which makes sense: if someone’s going to invest for longer, they’ll want it to be worth their while. So when short-term interest rates, like those on the 2-year Treasury, jump higher than long-term ones, like on the 10-year, we call it an inverted yield curve. In the chart, it’s every time the blue line drops below zero (the gray horizontal line)..

An inversion usually happens when the Fed is pumping the brakes on the economy by raising interest rates. See, investors know that those higher rates will clobber growth and eventually lead to rate cuts (hello, lower long-term rates). But the real clue about what lies ahead is in the curve's next move – steepening.

A "bull-steepening" (when both short- and long-term yields drop, but short-term ones nosedive more) is like a flashing red light, suggesting the Fed might slash interest rates pronto. And the Fed would only do so if economic growth (and thereby the labor market) is about to hit a nasty speed bump. And while stocks love lower rates, they hate falling growth: it shrinks their profits and pushes their valuations lower.

So, the yield curve dances like this: it flattens and inverts when investors sense a recession, then steepens just before the recession (gray shaded bars) kicks off. And guess what? Over the past month, the curve has been steepening – with the gap between the 2-year and 10-year moving from -110 basis points (or 1.1 percentage points) to -50 basis points (or 0.5 percentage points). In other words, it’s not subtly hinting that a recession could be just around the corner.

So make sure to hold some traditional safe-haven assets (like gold and Treasury bonds), defensive sector stocks (like consumer staples and healthcare), and defensive company shares (from high-quality firms). And be sure to keep a cash buffer on hand for when opportunities arise.

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