A Recession “Countdown” Just Triggered

Of course, a recession isn’t guaranteed. And let’s not forget how many on Wall Street spent much of late 2022 wrongly predicting a recession (including me).

Here’s a headline reminder from CNBC:

Source: CNBC

Let’s walk through all the details here so we can be mentally prepared for whatever is on the way.

Yield curve inversion 101

To make sure we’re all on the same page, a yield curve is a graphical representation of the yields of all currently available bonds, from short-term to long-term.

In normal times, the longer you tie up your money in a bond, the higher the yield you would demand for it. So, you’d expect less yield from a 2-year note and more yield from a 10-year note.

Given this, in healthy market conditions, we usually see a “lower left” to “upper right” yield curve. But when economic conditions become murky and investors aren’t sure what’s on the way, the yield curve tends to flatten.

And if the curve inverts, history has shown that it is a highly accurate predictor of recessions, though the timing of those recessions varies. From Reuters:

Yield curve inversion is a classic signal of a looming recession.

The U.S. curve has inverted [6 to 24 months] before each recession in the past 50 years. It offered a false signal just once in that time.

The most widely watched yield curve inversion involves the 10-year and 2-year Treasury notes. Until yesterday, this part of the yield curve had been inverted for more than two years.

If that seems like a long time, it is. Back in March, the inversion set a record for the longest continuous inversion of the U.S. 2s and 10s.

But while the term “inverted yield curve” has turned into an investment boogeyman, the real threat isn’t the inversion, it’s the period after the inversion normalizes.

Let’s return to one of our Digests from last October:

Using data from the Federal Reserve, let’s go back to the mid-70s and look at the timing of when inverted yield curves normalized and ensuing recessions.

In the chart below, we have the 10-2 spread. We also have recessions that are marked by shaded gray areas.

We’ve added a black dotted line to the 0% level to help you see inversions more clearly.

Note that this normalization of an inverted yield curve has preceded each recession except those in the early 1980s when the recessions began during the inversions.

(We’re ignoring the 2020 recession because there wasn’t a sustained yield curve inversion.)

Source: Federal Reserve data

If history repeats and we’re in for a recession, when might it begin?

Before we answer that, let’s clarify something…

Remember the old philosophical question “If a tree falls in a forest and no one is around to hear it, does it make a sound?”

The recent economic equivalent is “If the economy suffers a recession yet the government refuses to call it a recession, does Main Street really endure hardship?”

You may recall 2022 when the U.S. economy suffered two consecutive quarters of contractions: a 1.6% decline in Q1 2022 followed by a 0.9% slowdown in Q2. This met the traditional definition of recession used by economists for decades. However, many of our politicians and appointed officials refused to call it that.

For example, Treasury Secretary Janet Yellen preferred the happy talk that our economy was in a “state of transition.”

Here’s how a user on X poked fun of that comment:

Source: @JamesLavish

So, whether our government is willing to admit an official recession or not, let’s look at when the economic pain typically intensifies in the wake of an inverted yield curve normalizing.

The lag time between normalization and a recession (or a “state of transition”)

There are no hard-and-fast rules, but if we evaluate the prior 30 years, we’re looking at somewhere between six months and a year-and-a-half. Given the record length of the inversion this time around, the lag time could be shorter…or longer. No one truly knows.

In June 2007, the inverted yield curve normalized, and the Great Recession officially began six months later in December of 2007.

In January of 2020, the yield curve normalized, and the ensuing recession began in March of 2021, about 14 months later.

If we go all the way back to 1988, the yield curve normalized in December, then about 19 months later, we entered the recession.

But a couple of points to consider…

First, the investment pain doesn’t wait until the powers that be officially declare “recession.” You stock market history buffs know that stocks usually begin taking it on the chin well before an official recession began.

This makes sense for a couple reasons…

First, remember the reason why the Federal Reserve usually chooses to cut rates (which helps normalize the yield curve): fears of a recession.

Unfortunately, history shows that all too often, the Fed is late to the game. So, its rate cuts don’t stop a recession, they simply trumpet its forthcoming arrival.

On that note, almost on cue when the yield curve normalized yesterday, Atlanta Federal Reserve President Raphael Bostic said:

We cannot wait until inflation has actually fallen all the way to 2 percent to begin removing restriction because that would risk labor market disruptions that could inflict unnecessary pain and suffering.

You don’t say?

And just this morning, the ADP jobs report showed that private sector payrolls grew at the slowest pace in almost four years and was well below estimates. The Dow Jones consensus forecast was 140,000 but the actual number came in at just 99,000.

Also this morning, the jobs placement company Challenger, Gray & Christmas reported that this was the worst August for layoffs since 2009.

Not good.

Second, it makes sense that stocks would begin pulling back before an official recession because Wall Street always looks ahead.

Even though Wall Street and the economy loosely mirror one another, they rise and fall on different timetables, with Wall Street leading the way.

Here’s a crude illustration with stocks in green, frontrunning the economy in black.

In a report published in 2022, Goldman Sachs suggested that the low point in the stock market usually comes three to six months before the economy’s low-water mark.

For long-term investors, this means a couple things:

One, brace for the potential for a pullback in your favorite core holdings, but don’t let that scare you; two, clear up your cash so you can add to your positions in a handful of months if/when the market might be hitting its low (before the economy officially turns).

For traders, the takeaway is different: “get excited!”

For traders who know how to profit in both bull and bear markets, impending recessions are welcomed. After all, they can result in huge spikes in volatility which knowledgeable traders can profit from.

Our own Jonathan Rose is one such “knowledgeable trader.”

For newer Digest readers, Jonathan was a professional trader for over 16 years prior to joining our corporate family earlier this year. He traded in the “pits” of some of the biggest exchanges in the world – including the Chicago Mercantile Exchange and the Chicago Board Options Exchange.

One of Jonathan’s favorite ways to trade centers on volatility and how it impacts option pricing. While that might sound confusing, it’s rather simple.

In short, Jonathan looks for inconsistencies between the potential for heightened market volatility and how options are priced. When he finds an especially large inconsistency, that get his attention – and many times, results in a winning trade.