A Little Known But Powerful Recession Indicator Is Flashing Red

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While last week’s consumer inflation (CPI) readings may have opened the window for a recession, it may be too little and too late as a little-known but powerful bearish indicator started flashing red last week. The 10-year Treasury minus 2-year yield is perhaps the best-known predictor of recessions, and it turned red in April. Historically, a recession is occurring when the yield on the US 10-year Treasury falls below the 2-year yield, also known as inverting the yield curve. Since the 1970s, a yield curve inversion has occurred before everyone recession. The only flaw on its record is the 1998 reversal which produced no economic downturn after. Unfortunately, even when the signal is correct, it is usually about a year and a half before the bearish starts, so it is not conducive to bearish times. In addition, the stock market tends to rise higher after the mid-teens percentage and sometimes reversal.

In 2018, the Fed published a paper about a lesser-known but more robust predictor of a pending recession. The indicator is called “near-term forward spread”. It measures the current three-month Treasury rate by subtracting the projected three-month Treasury yield eighteen months into the future. While this may sound complicated, the near-term forward spread reflects the bond market’s expectation of a Fed rate change in the coming year and a half.

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While the 10-year minus 2-year yield curve has been inverted for some time, the near-term forward spread just upside down and produced its bearish warning last week. When the near-term forward spread is negative, the market is pricing a Fed rate hike over the next year and a half, and a recession is likely. Furthermore, a study by the Fed showed that the measure was also helpful in predicting future economic growth.

Like the yield curve, every recession since 1973 has been preceded by a near-term forward spread inversion. Again like the yield curve, the forward spread predicted a recession in 1998 that never materialised. The forward spread provides a more timely indicator of the last economic downturn and stock market peak than the yield curve. It usually reverses about a year before a recession and reverses between 18 and 2 months before the previous recession.

Furthermore, a Fed study referenced earlier also showed that the measure helped predict future stock returns. It’s worth warning that typical stock declines of more than 20% after indicating near-term forward spreads were just over eight events since 1973. Many other historical indicators, ranging from post-midterm election performance to historical performance. Markets falling by more than 20% provide a more optimistic estimate of forward returns.

With the stock market down about 12 percent from its lows, this bearish warning is probably a perfect time to reaffirm your risk tolerance and rebalance portfolio if necessary. While it is wise and prudent to remain optimistic about stock returns over any long term, the short-term path is unknown and much work remains to be done to control inflation. Given recessionary expectations, investors should maintain sufficient low-risk assets such as cash and high-quality bonds to support living expenses during an economic downturn. Upgrading a stock portfolio toward higher-quality and dividend-growth stocks would likely prove wise. This quality, valuation and dividend focus allows investors to stay invested with less worry during an economic downturn, which has always been the secret to long-term success.

Credit: www.forbes.com /

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