A Key Economic Indicator Points to Recession, but Stocks are at All-Time Highs. What Gives?

If I had to pick a single economic indicator to predict the direction of the US economy, it would have to be the yield curve.

But what exactly is it?

The yield curve is simply a curve on the graph of interest rates on US treasury bonds across various maturities (1 month to 30 years).

Interest rates (or yields) on the short end of the curve, i.e. smaller maturities, typically rise and fall depending on what the Federal Reserve (Fed) does, or is expected to do over the next year or two. If economic growth is strong, and if the Fed perceives there is a risk of overheating, they raise interest rates and the short end of the yield curve rises. On the other hand, if they believe a recession is imminent, they tend to lower rates.

Now interest rates on the long end of the curve, i.e. maturities of 5 years or more, are typically higher than those on the short end and a reflection of the broader bond market. If investors anticipate higher growth and inflation they will demand much higher long-term interest rates, widening the “spread” or difference between short and long-term rates.

Below you can see an example of a “normal” upward sloping yield curve; at the end of 2017 when economic optimism was riding high amid tax cuts and stimulus spending from Congress.

Hence all the talk about a recession.

So is a recession imminent?

The yield curve has inverted ten times over the past 60 odd years, and in nine of those times, a recession followed anywhere between 7 and 24 months later . No wonder that the inverted yield curve is one of the go-to indicators for an economic forecaster.

However, as the table below indicates, a recession does not immediately follow full inversion. The average lead time between full inversion and a recession is more than a year (14 months). In fact, the last time the yield curve inverted was in January 2006, and a recession was almost two years away. Wary bond markets were sensing a shift in the underlying economy well before the recession began in December 2007.

But stocks are close to all-time highs

This is where the apparent disconnect occurs. The yield curve, perhaps the single best forecaster of an economic recession, points to recession but stocks (at least in the US) are at or close to all-time highs. What gives?

In short, this is not strange.

I looked at how stocks performed in the wake of historical yield curve inversions (defined as a reversal in 10-year minus 1-year interest rate spread). The chart below illustrates how much the S&P 500 Index gained (or lost) in those nine instances when the yield curve correctly predicted a recession. Each panel illustrates cumulative gains for the S&P 500 price index starting from the month in which full inversion occurred through to the end of the recession.

The gray shaded area in each panel highlights the recession period. I should point out that the “official” start and end dates for a recession are declared well after it is done with. So in real-time, it's hard to pinpoint when exactly the economy is contracting.

In seven out of the nine cases, the S&P 500 gained 5% or more in the months between inversion and the start of the recession. The exceptions are 1973 and 2000.

As recently as 2007 we saw an extreme case: the S&P 500 gained more than 23% in the months following full inversion (which occurred in January 2006). It ended up losing all those gains and then fell by another -35% amid the recession.

Interestingly, in four out of nine cases (1960, 1980, 1981 and 1990), the S&P 500 price index gained across the entire period between full inversion and the end of the recession .

So there is no cut and dry case for closing all stock positions immediately after a yield curve inversion. As with any economic indicator, including one with a track record as the yield curve, it is best to probably combine it with other indicators.

Is this time different?

Federal Reserve officials are just as aware as anyone else as to what an inverted yield curve signifies. They pulled back from raising interest rates in 2019 as they began to realize that the economy may not be as strong as they believed it to be. At their most recent meeting (June 19th) they even signaled interest rate cuts in the second half of the year. Which is what sent stocks screaming up to new highs this past week.

Of course, it remains to be seen if the Fed can fend off a recession if at all they have the power to do so.

The other thing is that prior yield curve inversions have coincided with lower government spending. That is not the case today.

For the first time in recent history, the federal government is spending more, via tax cuts and getting rid of prior budget cuts it had made (sequestration) - fiscal stimulus if you may. As a result, the US government deficit is growing rapidly.

Now, this type of fiscal stimulus is typical only during recessions, or in their immediate aftermath. It is not common this deep into an economic expansion, especially one that has lasted as long as it has and is slated to become the longest expansion on record. I wrote about this last summer.

So could this time be different thanks to unorthodox fiscal policy and a Fed that is more tuned to potential risks — thus pushing a potential recession even further into the future?

Yet as Minneapolis Fed President Neel Kashkari points out , “this time is different” may be the four most dangerous words in economics.

Related: The Three Most Important Questions for the Global Economy in 2019