The inverted yield curve is signaling a recession

To predict a recession, economists look to certain indicators that have a reliable record of showing recessions. One of these indicators is the yield curve. Now, the yield curve is flashing red.

What is the yield curve?

The yield curve is a line that plots the yield, or interest rate, on bonds of different maturities and the same credit quality. Although yield curves can be plotted with bonds of any maturity, some of the most commonly used yield curves are the spread between the three-month Treasury bill or the two-year and 10-year Treasury bills, used to indicate the spread between short-term and long-term Treasury bonds.

Generally speaking, the yield curve slopes upward, with lower yields on short-term bonds and higher yields on long-term bonds. In other words, when you freeze your funds for a long period of time, you should receive a higher rate of return as compensation.

At some point, the yield curve may invert and start sloping downward. When this happens, short-term bonds have higher yields than long-term bonds, and investors are not rewarded for giving up money over the long term.

Why is the yield curve used to predict recessions?

When the yield curve is inverted, investors expect the Federal Reserve to lower the benchmark interest rate (federal funds rate) in the future, thus pushing down the yields on long-term bonds.

Jeanette Garretty, chief economist and managing director at California-based wealth management firm Robertson Stephens, said the inverted yield curve is used to forecast recessions because it signals investors Think about how the Federal Reserve will handle benchmark interest rates in the future.

“What tends to happen before a recession is that the Fed raises interest rates, (or) sets policy rates at short-term rates, and market participants become more pessimistic and they bet that rates will fall over time. “So you have a situation where yields on the short end of the yield curve may be higher than longer-term yields,” said Andrew Patterson, senior international economist at Vanguard Group. “

If the economy is currently experiencing high inflation and low unemployment, the Fed will raise interest rates to reduce demand and curb inflation. Once higher rates hit the economy – cooling inflation and causing unemployment to rise – the Fed may need to cut rates to encourage consumers and businesses to spend again.

So how long does it take for a recession to occur after the yield curve inverts? Both Galletti and Patterson estimate it will take about six to 12 months for a recession to occur.

While economists often rely on the yield curve to predict recessions, it’s not always a foolproof indicator.

“Every recession we’ve seen has been preceded by a yield curve inversion,” Garetti said. “That’s not to say that every yield curve inversion heralds a recession.”

A 2018 report showed that since 1955, the yield curve has only had one false positive: in 1966, the yield curve inverted but was not followed by a recession. San Francisco Federal Reserve Bank Report Starting in 2018.

What is the yield curve telling us now?

The two-year and 10-year Treasury yield curves inverted on July 5, 2022, and have remained that way ever since.The yield curve has been inverted for more than a year, and the economy is still booming—the unemployment rate is 3.8%, inflation is down to 3.7% annually, and consumers Still consuming.

“The United States is not in recession,” Garetti said. “The labor market is generating a lot of income for people – they’re getting real increases in wages… No one is happy with these price increases, but they have enough income to manage it.”

While the economy and consumers appear to have yet to feel the impact of the Fed’s rate hikes, which have gone from near zero to more than 5% over the past 18 months, Patterson did not rule out the possibility of a recession yet.

“While yield curves of this duration have typically led to recessions in the past, there is good reason to believe that recessions have been delayed as the housing market remains resilient and the labor market is strong,” Patterson said. “Recession remains our base case. Sometime in 2024.”

Only time will tell whether the recent yield curve inversion accurately predicted a recession.

“If predicting a recession was as simple as looking at the yield curve… you would see more economists saying, say, at two o’clock on November 16th, there will be a recession – which is obviously not that easy,” added Reti said.

Defeat your finances against a recession

While it’s uncertain whether a recession is imminent, there are several ways to prepare, such as analyzing your spending, paying down debt, investing, and building emergency reserves.

Prioritize paying off credit card debt

With interest rates at their highest levels in more than 20 years, holding credit card debt has become prohibitively expensive: The average annual percentage rate (APR) for credit cards is over 20%.

Paying off credit card debt may require taking a closer look at your spending – are there any discretionary expenses you could cut? Or do you need to supplement your income by starting a side hustle or pursuing a job promotion?

If you have debt on multiple cards, you can also use a popular debt repayment strategy—the avalanche or snowball method.

Using the snowball method, you pay the smallest balance first and then the larger balances, which can give you quick wins. If you want to focus on saving more money, you can use the avalanche method, which involves prioritizing paying off debt with the highest interest rate before moving to debt with lower interest rates.

Build your emergency fund

Of course, when a recession occurs, unemployment usually rises. To prepare for a layoff, experts typically recommend saving three to six months’ worth of living expenses in an emergency reserve. Saving is as easy as having automatic monthly payments from your checking account to a high-yield savings account. Tip: You can now earn over 5% with a high-yield savings account.

Invest in recession-resistant assets

During an economic downturn, stock values ​​typically decline as consumers and businesses spend less. However, some assets are less susceptible to volatility during a recession.

Stuart Katz, chief investment officer at Robertson Stephens Wealth Management, recommends investing in companies that offer consistent dividends during recessions or periods of high inflation, as these companies typically have more resilient business models.

Another option is defensive stocks from industries like healthcare or utilities. These stocks are considered less sensitive to changes in the economy because consumers still have to pay their electric bills and medical bills regardless of how the economy performs.

Finally, instead of investing in individual stocks, consider putting your money into low-fee exchange-traded funds (ETFs) or mutual funds that generate dividends and invest in defensive stocks. ETFs and mutual funds allow you to invest in multiple companies at the same time, giving you instant diversification.

takeout

The current inverted yield curve tells us what investors think about the future economy: due to the recession, the Federal Reserve will need to cut interest rates. However, when the yield curve inverts, it’s not always an indicator of a recession — even if it has been in the past.

Whether or not a recession happens, it never hurts to be prepared for one, whether it’s growing your emergency fund or paying down high-interest debt.