Recession talk has been in the air for a while. So far, though, no recession has materialized. It's perhaps been the most hyped recession that never was.
However, don't think that we're out of the woods yet. Actually, there could even be more of a reason to worry now. One widely followed recession indicator just flashed its biggest warning sign since 1981.
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The go-to indicator
The yield curve arguably ranks as the most popular indicator of a potential recession. This curve compares short-term U.S. Treasury rates (for example, two-year rates) against long-term U.S. Treasury rates (such as 10-year rates).
Ordinarily, investors expect longer-term rates to be higher than shorter-term rates. After all, committing money for a longer period involves a higher level of risk. It makes sense that rates would be higher.
However, at times the yield curve can invert. In other words, short-term rates can be higher than long-term rates. This can happen when investors are concerned about the future of the economy. They're willing to lock in lower long-term rates because of this uncertainty.
The two-year/10-year U.S. Treasury yield curve has a great track record of predicting recessions. Historically, when this yield curve inverts, it has predicted a recession within the next two years 98% of the time.
Biggest spread in decades
Many investors were therefore concerned when the yield curve inverted last summer. The last eight times that happened, the U.S. economy subsequently entered a recession. But last week, the spread between the two-year U.S. Treasury yield and the 10-year yield was the widest since 1981. The recession indicator reached this point after Federal Reserve Chair Jerome Powell stated that higher interest rate hikes could be on the way.
Powell noted in his remarks to the Senate Banking Committee on March 7 that economic data has been stronger than expected. Inflation also remains stubbornly high. As a result, the Fed could be forced to be more aggressive with its interest rate increases.
Since then, though, the yield spread has improved somewhat. That's primarily because the failure of Silicon Valley Bank could cause the Federal Reserve to back off its plans for significant rate hikes. Goldman Sachs wrote to its clients on Sunday that it doesn't expect any interest rate increase when the Fed meets next week.
But investors shouldn't become complacent. Even with the improvement this week, the spread between the two-year and 10-year Treasury yields is still the greatest it's been in decades. And even though Goldman Sachs doesn't forecast a rate hike next week, the big bank still anticipates that the Fed will continue to increase interest rates this year.
10-2 Year Treasury Yield Spread data by YCharts
The shaded areas in the chart shown above show periods when the U.S. economy was in a recession. Note that the yield spread bounced back at least somewhat before most of the recessions over the past 40-plus years.
Investors' best strategies
Investors with long-term mindsets really don't have to pay much attention to yield curves and spreads or any recession indicator. The stock market ought to deliver solid returns over the next 10 years and beyond.
Still, though, investors shouldn't ignore the real possibility that a recession could be on the way. Stocks typically (although not always) fall quite a bit during recessions. It's not a bad idea to have cash built up to take advantage of what could be a tremendous buying opportunity.
Investors can also consider buying recession-proof stocks. These stocks tend to hold up well even during economic downturns. For example, discount retailers can enjoy solid sales growth during a recession. Patients also need their prescription drugs, so some biopharmaceutical stocks can perform well despite economic headwinds.
Keep in mind, too, that recession indicators such as the yield curve aren't always perfect. They can also flash well ahead of the beginning of a recession.
