Sell Now or Sell Later? It All Depends on How You Interpret the ‘Recession Indicator’

The bond market sent a recession warning on Wednesday. The bond market flashed a troubling signal about the U.S. economy. An inverted 2-year, 10-year Treasury yield spread has been a reliable indicator of economic recessions. An inversion of the yield curve is an indicator of a coming recession. The U.S. yield curve “is a major recession indicator.”

These are a few of the headlines or sentences investors were exposed to on Wednesday. So what do investors do? “Sell today and go away for ????.” What I mean is when does the recession start? How long will it last? How do we know when it’s over? Difficult questions to answer because the lead time preceding each recession is volatile. Furthermore, other factors usually accompany the economic signal.

You can go with the doom and gloom headlines, or you can follow the research. I guess it all depends if you’re a pessimist or an optimist?

Are We There Yet?

Throughout the year, I’ve seen quite a few articles on how inverted yield curves predict recessions. I think I started to see these predictions during the summer of 2018 when a rise in short-term rates narrowed the spread between the 3-month bill rate and the 10-year yield to levels not seen since the financial crisis. That part of the yield curve eventually inverted, yet stocks continued on their way to new highs.

We’ve also seen recession forecasts appear when the 2-year inverted with the 5-year. In fact, we’ve seen inversions all over the yield curve this year, and with each came the inevitable recession forecast, On Wednesday, however, the granddaddy of all yield curve inversions took place when the 10-year U.S. Treasury yield dipped below the 2-year Treasury yield. Now, does a “dip” count? Or does it have to remain inverted for 1 day, 1 week, or 1 month or more?

Historical Analysis May Clear Up Any Confusion or Add to It

Let’s cut to the chase. Historical analysis shows that stocks typically have another 18 months to rally before equity markets start to see signs of trouble. So why the sell-off on Wednesday? Is it because traders just increased bets that the 2-10 inversion was the most reliable recession indicator to watch?

“While an inversion has preceded each recession over the past 50 years, the lead time is extremely inconsistent,” Jonathan Golub, chief U.S. equity strategist at Credit Suisse, wrote in July 2018. “Historically, an inverted yield curve has been accompanied by a variety of other ominous economic signal including layoffs and credit deterioration.”

Here’s another variable to deal with. According to Credit Suisse, the market rallies more than 15% on average in the 18 months following the inversion. Furthermore, a recession hits in 22 months after the inversion.

Bank of America Merrill Lynch analysts say, “Sometimes the S&P 500 peaks within two to three months of a 2s10s inversion but it can take one to two years for an S&P 500 peak after an inversion.”

They further added, “The typical pattern is the yield curve inverts, the S&P 500 tops sometime after the curve inverts and the U.S. economy goes into recession six to seven months after the S&P 500 peaks.”

Janet Yellen Says Inversion May Be False Recession Signal This Time

In the wake of Wednesday’s steep stock market sell-off, former Federal Reserve Chair Janet Yellen said markets should place less weight on this yield curve inversion.

“Historically, [the yield curve inversion] has been a pretty good signal of recession and I think that’s when markets pay attention to it but I would really urge that on this occasion it may be a less good signal,” Yellen said on Fox Business Network.

She further added, “The reason for that is there are a number of factors other than market expectations about the future path of interest rates that are pushing down long-term yields.”

When asked if the United States is headed into a recession, Yellen said:  “I think the answer is most likely no. I think the U.S. economy has enough strength to avoid that, but the odds have clearly risen and they’re higher than I’m frankly comfortable with.”