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Recession indicator flashing red?

It used to be pretty easy to figure out if we were headed for a recession. Interest rates were one of the best and most reliable signals. But in this era of near-zero rates, it may be more difficult to rely on them as a telltale indicator.

Usually, shorter-term Treasurys have a lower yield than longer-term ones. Since it is usually riskier to loan money for a long period of time, the longer the maturity of the bond, the higher the yield, or return.

In normal circumstances, the 10-year treasury yield minus the 2-year treasury yield is expected to be a positive number, since the returns on a long-term 10-year bond should be higher than a 2-year one.

10-year Treasury yield minus 2-year Treasury yield
10-year Treasury yield minus 2-year Treasury yield

However, over the past four decades there have been some dips into negative territory, which is called a yield curve inversion. On average, recessions, highlighted in grey, start less than a year after the yield curve inverts. Every recession since World War II has been forecasted by this very phenomenon.

Why would this happen? Let’s take the mid 2000s as an example. The economy was doing well, and in 2004 the Fed started to raise rates. Knowing that when the Fed is in a rate-hiking cycle and that growth is likely to slow, investors want to lock in those higher rates before a downturn. In 2005, demand for longer-term bonds was so high that their return dropped below those issued over shorter terms.

Fed Funds rate and recessions
Fed Funds rate and recessions

Currently, the spread between the 10-year and 2-year yields is shrinking, but we are nowhere near seeing an inversion.

However, this time could be different, notes Ruslan Bikbov, a strategist at Bank of America Merrill Lynch. “Because rates are so close to zero, it will be difficult to see them invert before a recession,” he said.

Bikbov created a model to adjust for rates near the zero lower bound. He compared the 5-year rate and the 3-month rate for overnight index swaps, and it is signaling that the yield curve has already inverted.

BofA overnight index swaps yield curve model
BofA overnight index swaps yield curve model

However, it is worth taking this with a grain of salt. As global central banks wade into uncharted territory by testing the zero lower bound, interest rates are increasingly unreliable indicators, even with adjustments. Accordingly, any predictive measure based on historical trends is good to be aware of, but should be applied with caution.

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