There are very few market indicators that can predict recessions without sending out false positives.
The yield curve is one of them.
At a breakfast earlier today, LPL Financial’s Jeffrey Kleintop noted that the yield curve inverted just prior to every U.S. recession in the past 50 years.
“That is seven out of seven times — a perfect forecasting track record,” he reiterated.
The yield curve is inverted when short-term interest rates (e.g. the 3-year Treasury) are higher than long-term interest rates (e.g. the 10-year Treasury yield).
“The yield curve inversion usually takes place about 12 months before the start of the recession, but the lead time ranges from about 5 to 16 months,” wrote Kleintop in a recent note. “The peak in the stock market comes around the time of the yield curve inversion, ahead of the recession and accompanying downturn in corporate profits.”
The Federal Reserve has been signaling that tighter monetary policy is on its way, which means short-term interest rates should move higher. Is this something we should be worried about? Kleintop offered some context:
How far the Fed must push up short-term rates before the yield curve inverts by 0.5% depends on where long-term rates are. Even if long-term rates stay at the very low yield of 2.6% seen in mid-June 2014, to invert the yield curve by 0.5% the Fed would need to hike short-term rates from around zero to more than 3%. Based on the latest survey of current Fed members that vote on rate hikes, they do not expect to raise rates above 3% until sometime in 2017, at the earliest…
Lots of economic and market factors drive what happens with interest rates. So the shape of the yield curve is definitely worth paying attention to.
“The facts suggest the best indicator for the start of a bear market may still be a long way from signaling a cause for concern,” he said.