One of the top recession indicators flashed a warning signal about 15 months ago, and now, it's getting louder and brighter.
Two-year Treasury bonds started to yield more than 10-year T-notes last summer in what's called a yield-curve inversion. In normal times, the yield curve slopes up and to the right. That is, longer-dated bonds offer a higher yield than shorter-dated bonds. That gives investors a greater reward for holding their investment longer.
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However, with expectations for the Federal Reserve to tighten the money supply and make it harder to borrow, investors moved money away from short-term bonds to long-term bonds. That led to an inverted yield curve, which signals investors' pessimism regarding the near-term economic outlook. Indeed, an inverted yield curve has preceded each recession since World War II.
Now, the difference in Treasury bond yields is flashing a signal that a recession could be imminent.
The yield is "re-steepening"
After 15 months, the yield curve is clawing its way back to flat.
The gap between the 2-year Treasury bond yield and the 10-year has shrunk from more than 1% at the start of July to less than 0.3% today. This is called "re-steepening."
Data by YCharts.
Re-steepening can be an immediate precedent to a recession and generally happens during a recession itself. Each of the last four recessions saw re-steepening happen before the recession actually started.
There are two ways the yield curve can steepen.
First, long-term yields can decline more slowly than short-term yields. This is called a "bull steepener" and it would occur when the Federal Reserve is expected to lower interest rates. It indicates near-term optimism about the economy, because it should become easier for businesses and consumers to borrow.
The second way the curve can re-steepen -- the one we're seeing now -- is when long-term yields increase faster than short-term yields. It doesn't happen very often, but it's called a "bear steepener." We've seen the yield on 10-year T-notes increase more than 1 percentage point since midyear, while the 2-year yield rose about 35 basis points.
Usually, we see a bear steepener at the start of an economic cycle, after a recession. After all, when long-term bond yields rise, it's usually because investors are selling bonds and buying stocks. They're betting on a brighter future for the economy.
But this bear steepener is happening amid an inverted yield curve, which may signal the start of a recession.
Two explanations for the signal
Long-term yields climbing faster than short-term yields is usually a sign of long-term economic optimism.
Short-term yields are much more sensitive to what the Fed does, and the market believes the Federal Reserve is done raising interest rates. Futures traders imply just a 3% chance of a rate hike at the next Federal Open Market Committee meeting on Nov. 1.
Meanwhile, long-term bond yields are based on growth expectations. If investors expect to avoid a recession, they'll sell off long-term bonds and put their money to work in stocks. That results in higher long-term bond yields.
But there's another explanation.
"We have an abnormal supply-demand situation in that the quantity of debt the government has to sell is a lot," billionaire investor Ray Dalio said in an interview with Bloomberg earlier this month. Dalio's comments follow an announcement from the U.S. Treasury this summer that it would increase the number of bonds it issues in Q3 and likely boost that figure further in subsequent quarters.
This second explanation is a much worse signal for stocks than the first. It means demand for long-term Treasuries isn't necessarily declining as investors shift to stocks. Instead, it indicates a much less sunny long-term outlook for the economy, and it could give the Fed more reason to keep raising interest rates.
Higher borrowing rates for businesses mean costs increase. And as companies look to cut costs elsewhere, it could lead to a weakening labor market.
Are we headed toward a recession?
There's no way to forecast the future with 100% accuracy. If you could reliably predict the start and duration of a recession just by following the path of the yield curve, we might never actually see a recession.
But the current yield curve and the manner in which it's re-steepening suggests investors should be wary of the market.
So, what are investors to do?
The best path forward is to take the long-term view. Recessions are a natural part of the economic cycle. Over long periods of time, however, we've seen massive increases in GDP, despite the occasional setback. The average recession lasts just 17 months. By contrast, the periods of economic growth in between can last for years.
Investors who stick with stocks over the long run are far more likely to generate positive returns than those who try to time the market around recession indicators. Indeed, the S&P 500 has yet to fail to produce real positive returns for investors over any 20-year period in history, despite encountering a recession or two.
So the simplest strategy, even if you fear a recession is around the corner as the yield curve suggests, is to buy and hold quality stocks for the long run.
