The Federal Reserve has aggressively fought inflation over the past year. Policymakers raised interest rates at their fastest pace in four decades, while simultaneously shrinking the Fed's balance sheet, which doubled in size during the pandemic. Those actions have inflation trending downward, but they have also brought the economy to the brink of recession.
In fact, Fed officials now expect the U.S. to slip into a mild recession before the end of 2023. That prognosis coincides with an inversion in the U.S. Treasury yield curve, an indicator that has preceded every recession since 1955. Here are the details.
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Yield curve inversions signal a lack of confidence in the economy
Under normal circumstances, U.S. Treasury yields form an upward-sloping curve when plotted graphically, meaning bond interest rates rise as bond durations lengthen. For instance, a 10-year Treasury note pays more than a 3-month Treasury bill. That happens because long-dated bonds are riskier than short-dated bonds, so investors demand greater compensation. A 10-year Treasury leaves more room for inflation to reduce returns, and it increases the risk that the bondholder will miss other investment opportunities (i.e., because funds are locked up).
However, the curve can invert -- a situation in which short-term Treasuries pay more than long-term Treasuries -- when investors lose confidence in the economy. Under those circumstances, short-term Treasury yields are higher because investors expect interest rates to rise in the near term, and long-term Treasury yields are lower because investors expect the higher cost of borrowing to hurt the economy, ultimately forcing the Federal Reserve to lower interest rates.
Yield curve inversions have been an accurate recession indicator
The U.S. economy has gone through 10 recessions since 1955, and each one was preceded by a yield curve inversion between the 10-year Treasury and the 3-month Treasury. The lag time varied from six months to two years, but the trend is still noteworthy. That portion of the yield curve is once again inverted today, as shown in the chart below.
10 Year-3 Month Treasury yield spread data by YCharts
For context, the chart plots the yield spread between the 10-month Treasury and the 3-month Treasury. If the trend line is negative, the yield curve is inverted. Recessions are marked by gray bars. Investors should note that the yield curve is more steeply inverted today than it has been at any other point since 1960.
Investors should also glance at the inversion that occurred in 2019. While that event was followed by a recession, the recession itself was almost certainly caused by the pandemic. Forced business closures and social distancing mandates sank the economy like a stone. The bond market cannot possibly predict black swan events, so that particular yield curve inversion may have been a coincidence. There is no way to know if the economy would have slipped into a recession if the pandemic had never occurred.
Here's the bottom line: Past events never guarantee future results, but investors should mentally prepare themselves for a recession. A growing body of evidence suggests the economy is headed for a downturn, including recent commentary from the Federal Reserve, the inverted yield curve, and the shrinking M2 money supply.
Investors who wait for robins will miss the spring
In October 2008, the S&P 500 was down 40% amid the global financial crisis, and many investors correctly assumed the market was headed lower. But Warren Buffett took that opportunity to write an illuminating op-ed piece for The New York Times, offering insight that is once again relevant today:
I haven't the faintest idea as to whether stocks will be higher or lower a month or a year from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.
Research from JPMorgan Chase corroborates that assertion: In every recession of the past 50 years (except one), the S&P 500 began climbing toward new highs before economic activity reached a bottom. In other words, the stock market was already going up while gross domestic product was still going down. That means investors who waited for definitive proof of an economic recovery probably missed a portion of the rebound. Mistakes like that can do lasting damage to a portfolio.
For that reason, investors should stay invested (and keep investing) whether or not the U.S. economy is headed for a recession. The next bull market could begin at any time.
As discussed above, the economy has suffered 10 recessions since 1955, but the S&P 500 still produced a total return of 10.3% annually during that period.
