The S&P 500 fell into a bear market last year as economic uncertainty rippled through Wall Street. When inflation reached a 40-year high, the Federal Reserve began raising interest rates. But the central bank was more aggressive with its monetary policy than many investors anticipated. Fed policymakers raised interest rates at their fastest pace since the early 1980s, and many experts worried that the rapid tightening will tip the U.S. economy into a recession.
Two economic indicators, in particular, are sounding very loud recession alarms. Here's what investors should know.
1. The Treasury yield curve is inverted
The first economic indicator sounding the recession alarm is the Treasury yield curve. Under normal conditions, long-term bonds pay higher interest rates than short-term bonds. This is because investors who buy long-term want to be compensated for the opportunity cost of their money. Anyone who locks capital in a bond for several years feels they deserve a higher interest rate than someone who locks capital in a bond for a few months. If you plotted the bond rates on a chart from short-term to long-term and connected the dots, they would form a line starting low on the left and rising as it moved to the right. This visual presentation is what is meant by the yield curve.
But sometimes that curve changes shape.
When short-term bonds start paying higher interest rates than long-term bonds, the line on the chart starts high and flattens or curves down for longer-term bonds. At this point, the yield curve is said to be "inverted."
Investors worried about recession look for inversions across a number of different Treasuries, but they monitor the spread between the 3-month Treasury bill and the 10-year Treasury note especially closely. That portion of the yield curve has inverted before every recession in the last 50 years, and it is currently inverted today.
The chart below shows the yield differential between the 3-month Treasury bill and the 10-year Treasury note. The curve is inverted any time the trend line drops below zero, and the gray bars signify recessions.
10 Year-3 Month Treasury Yield Spread data by YCharts
As illustrated above, the 3-month Treasury yield currently exceeds the 10-year Treasury yield by 1.56%, meaning investors expect the Federal Reserve to lower interest rates in the future. More specifically, investors expect the currently high cost of borrowing to hurt the economy to such an extent that the Fed is forced to ease its monetary policy.
2. The M2 money supply is declining
The second economic indicator signaling recession is the M2 money supply, which measures relatively liquid currency in the economy. Specifically, M2 includes M1 (cash in circulation and checking accounts) as well as cash in savings accounts, money market accounts, and certificates of deposit. In general, M2 has increased steadily throughout history, but the pattern broke a few months ago.
The M2 money supply declined in December, January, and February. The last time M2 declined was December 1958, and a recession followed in April 1960. But the decline of December 1958 was a mere 0.16%, much more modest than the 2.35% decline that just occurred in February. In fact, M2 hasn't fallen more sharply than 2.35% since the Great Depression.
Those economic indicators should matter very little to patient investors
Taken together, the inverted yield curve and the M2 decline suggest that the U.S. economy is headed for a recession. Of course, past events are never a guarantee of future results, but many experts expect an economic downturn. For instance, JPMorgan Chase analysts put the odds of a U.S. recession at greater than 50% before the end of 2023.
But aside from acknowledging the possibility, patient investors should not react to the information discussed in this article.
There are two reasons for that. First, the S&P 500 began its rebound before economic activity bottomed out during every recession in the last 50 years, with only one exception. That means investors waiting for definitive proof of an economic recovery will almost certainly miss a portion of the rebound, and that can do lasting damage to a portfolio.
Second, the S&P 500 weathered seven recessions and six bear markets (excluding the current one) over the last 50 years, but the index still produced a total return of 9.9% annually during that time. That means patient investors ultimately have nothing to fear from a recession.
