There’s a market phenomenon that has a long track record of predicting recessions. It’s called a “yield curve inversion." Such an event occurs when the yield on short-term bonds, such as 1-year Treasuries, are higher than long-term bonds, such as 10-year Treasuries. Normally the yield on longer-term bonds have to be higher to compensate investors for locking up their cash for longer (the longer the maturity, the more uncertainty and risk the investor faces). So it's highly anamolous when a short-term bond’s yield is higher than a long-term bond's. Curve inversions have “correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession”.
Why would short-term bonds have yields higher than long-term bonds? Investopedia:
- When the economy is heading to a recession, knowing interest rates are to trend lower, investors are more willing to invest in longer-term securities immediately to lock in current higher yields. This, in turn, increases the demand for longer-term securities, boosting their prices and further lowering their yields.
It can be a bit tautological--investors sense a recession, and so behave in a way that signals recession--but the advantage of yield curves is the "wisdom of the crowds" tempered by everyone putting their money where their mouths are.
Yet while I understand the increase in demand for long-term bonds, raising their prices and lowering their yields, I don't understand why short-term bonds see a relative decrease in demand, a drop in price, and an increase in yield. From the same Investopedia:
- Meanwhile, few investors want to invest in shorter-term securities when presented with lower reinvestment rates. [Emphasis mine] With lower demand for shorter-term securities, their yields actually go up, giving rise to an inverted yield curve when yields on longer-term securities have come down at the same time.
If I'm to understand this, the demand (and therefore price) for shorter-term bonds falls... because when those bonds mature, we'll be in that recession and there will be lower reinvestment rates? Even if your bonds mature in the middle of a recession and you find yourself with cash and few good fixed-income options, at least you made some initial yield, no?
Nevertheless, the yield curve inversion is fascinating--as fascinating as the world of fixed-income securities gets. I've gone back to read the contemporaneous response of the pre-Global Financial Crisis yield inversion. It's similar to our current pending inversion, namely, fund managers and central bankers discounting the prescience of curve inversions. Bernanke in March 2007:
- "There’s been a good bit of evidence that the declines in the term premium and perhaps a great deal of saving chasing a limited number of investment opportunities around the world have led to a somewhat permanent flattening or even inversion of the yield curve, and that pattern does not necessarily predict a slowing in the economy or recession."
How hard can we bust balls here? It's easy in retrospect. However, there are lots of people saying that this time is different, too. QE and central bank support of bond markets may have distorted the signal. I don't buy it. Neither do Fed researchers who basically say that an inversion predicts an economic slump, no matter the driver of the inversion.
To summarize some historic statistics about yield curve inversions from my notes, it took an average of 10 months between the time that the yield curve inverted and the peak of the stock market, and an average of 5 months between historic market peaks and the start of recessions. If the yield curve inverts by the middle of 2019 (something that Morgan Stanley analysts believe, although I've heard estimates of inversion as early as December 2018), the current bull market would peak in April 2020 and the next U.S. recession would start in September 2020.
Timing the market is ill-advised, and this is a highly imperfect estimation. But it’s all but certain that the business cycle will bring another recession. I’d hedge strongly based on the yield curve. Does anyone wanna make a prediction? I place 70% confidence that a 10-year US Treasury compared to the 2-year US Treasury will invert sometime within a month of February 2019, and then within 12 months of that inversion we will see the peak of the bull run, and then 6 months from the peak will be a recession. This is confidence is borne of a complete amateur not even running line-of-best-fit software. By the way, that differential today is .22% from a .88% a year ago, 2.5% five years ago.
If the prediction were true, what then? This is helpful in so far as selling assets e.g. a house is easier in a bull market. People feel wealthier with rising asset prices. The Warren Buffet take is (probably) not to time markets but, failing that, not buy when everyone else is buying. That means holding or selling, building up cash for the discounts sure to come in ~2 years from now.
[Written while/instead of studying the night before an economics midterm.]
Edit to add: It surprised me that this phenomenon was only first documented in 1986 by a Duke economist. I thought such a strong predictor would have been discovered or postulated sooner.