Recession Indicator?

An inverted yield curve has historically predicted recessions in the U.S. It is, of course only one of several intel points to observe. Today’s headlines are a paradox; ADP’s jobs report topped expectations showing a strong economy and the Treasury yield curve is showing signs of  inversion indicating short term concerns of economic risk. The 2/10 year comparison is most common for this indicator. There is a noticeable inversion between 1-6 month versus 10 year of 100-150 basis points. 

Yield is a product of perceived risk. So there is more perceived risk in a 30 day Treasury than a 30 year Treasury? 

Inverted yield curves do not cause recessions. Lower long term yields commonly happen during recessions. So, when long term investors take a flight to safety bond values rise causing yields to go down. Short term investors see more opportunities outside of bonds causing lower bond prices resulting in higher YTM (yield to maturity or simply yields). 

Bonds are issued at $1000 face value with an interest rate paid semiannually to the holder of record. When it matures the holder can redeem it for $1000. Let’s say for example that a bond is issued at 5% interest rate. When new bonds of a similar risk profile are issued with a higher rate then the market value of our example bond will go down. A buyer wants a benefit for accepting a lower interest rate. When new bonds are issued at a lower interest rate sellers will demand a higher selling price because the interest rate they hold is now more valuable. 

YTM is the combination of a bond’s coupon rate or interest rate and the bond’s market price. A bond paying 3% interest trading at par value of $1000 will have a 3% YTM. It will have a lower YTM when that same bonds trades in the open market above $1000. Its YTM will be higher when the bond trades for less than $1000 because the new owner will receive the interest plus the full $1000 face value at maturity.

A leading indicator and impact

Of the six major U.S. recessions in the past half century all were preceded by inverted yield curves extending 2+ months. This is a normal part of the economy. It’s not good or bad. It is opportunity if you navigate it successfully. 

Different classes of investments are impacted differently under this condition. Banks depend on short term borrowing and long term lending. It’s easy to see how their profits are impacted.

Stocks that pay high dividends become less popular as investors can get higher short term yields without the risk of equities. When enough investors reposition to bonds the value of stocks decline pushing dividend yields up thereby attracting back their investors.

Consumers looking for short term financing may delay a purchase. Consumers with variable rate mortgages and credit cards will see their payments increase. These will ripple through the economy as less purchases are made. 

Effect on stocks

A slower economy lowers popularity of equity investing causing stock values to decline. Professional investors start taking advantage of lower prices as they live by “buy low, sell high.” The typical novice investor fears stocks down in value and wait for a stock to become hot before they jump on the bandwagon. Trust me, investing like the professional makes more sense for any type of investor. The best way to overcome typical novice investment fears is to learn more. 

Before a recession Consumer Staples have historically been attractive. Since many people are chasing what’s hot in an economic expansion, Consumer Discretionary for example, Consumer Staples will typically be out of favor. A good buying opportunity for the wise investor. The scenario is reversed in a recession. Financials, technology and commodities usually suffer lower prices too. Remember, buy low, sell high. Yes it really is that simple.

Effect on individuals

The impact of a recession on you cannot be known in advance. But, preparing for negative outcomes is simple. Increase your emergency fund, stop spending and reallocate your investment portfolio to its intended asset allocation model.

If you own a business start evaluating reduced hours and layoffs. Work with your consultant in advance to plan your contingency strategy. Start looking toward evergreen opportunities For example, if you own a plumbing business new construction opportunities will dry up temporarily but emergency plumbing issues will always be there. A lending business will see fewer applicants for large purchases but will see more opportunities in debt consolidation. If your business deals primarily with high net worth clientele you may not see much of an impact.

If you work for someone else get whatever additional job training available to you, take on a part time job now while the opportunity is available and update your resume. 

Recessions are a normal part of the economic cycle. The same economy that delivers good times, too. Be highly wary of and actively campaign against the politicians who claim they can control the ups and downs like we heard so often post Great Recession.