An inverted yield curve is one of the most reliable leading indicators of an ensuing recession.
That is, when longer maturity Treasury yields such as that of 10, 20, or 30-year bonds are lower than the yields of short-term Treasury yields, this signifies the market betting that the Federal Reserve will soon lower the overnight rate. A lower overnight rate will ripple out to lower short-term rates.
It's up for debate whether an inverted yield curve still works well as a leading indicator of economic weakness ahead. Those who say it doesn't have their reasons for thinking so, but I would prefer to err on the side of the reliability of an inverted yield curve rather than argue that its relevance is obsolete. This time, in my judgment, is not actually that different, despite the perennial assumption near market peaks that it is.
I want to explore when the stock market tends to fall leading up to recessions, and when to expect a potential future recession to start based on historical occurrences of inversions.
Stock Performance Before and During Recessions
Leading up to prior recessions, when did stocks (as measured here by the S&P 500) fall?
The recession of the early 1990s was relatively mild, and stocks did not fall at all until after the recession had started. This is true also of the brief recession in 1980 as well as the recession of 1981 and 1982 (not pictured below).
Prior to the recession beginning in 2001, stocks started falling about six months out. And prior to the official beginning of the recession in December 2007, stocks began falling from their peak only about a month out.
Prior to looking at this chart, I held the mistaken belief that the stock market tends to begin falling a long way out from the actual beginning of recessions — perhaps a year or so. I assumed that investors are usually able to predict oncoming economic weakness and discount stocks ahead of time. It turns out that the stock crash preceding the 2001 recession was a historical anomaly and that normally stocks don't fall until economic weakness forces a change in investor psychology. Likely, the case of the early 2000s is an anomaly because of the extreme tech stock run-up that deflated into the 2001 recession.
Yield Curve Inversions and Recessions
The 10-year minus 1-month Treasury yield is one way to measure inversion. This metric is now roughly as inverted as it was in late 2006 or early 2007.
Source: EcPoFi Blog
The 10-year minus 1-month yields un-inverted about six months prior to the official beginning of the recession in December 2007. It was about nine months from the time that this metric began steepening from its inverted lows, and it continued steepening until and through the recession, peaking once during and then again coming out of the recession.
The bear market for stocks, measuring from the last record high, began a little before the onset of recession and hit a trough near the end of it. We won't be able to judge exactly how far off a recession lies, according to this indicator, until the curve steepens to the point of un-inversion.
The 10-year minus 2-year Treasury offers another historically reliable leading indicator of recession ahead.
The 10-year minus 2-year barely inverted in June 1998, but it turned out to be a false flag as the curve went positive again for another year and a half. Then it inverted and remained so from February through November of 2000. The recession began four months after the un-inversion, and a little over a year after the initial inversion.
Then it inverted for two months in January-February 2006, then again from August 2006, remaining inverted through February 2007. The recession began eight months after the un-inversion, and a year and four months after the initial inversion.
In today's context, we've only seen this curve barely invert in August 2019, and it is now un-inverted. We'll have to wait and see if the downward trend continues in the months ahead. In either case, based on the two previous recessions, the beginning of the next recession isn't likely to come for at least another year, if the 10-year minus 2-year Treasury yields are any guide.
Given that the Fed has already cut rates once this cycle, it might be instructive to look at how much the Federal Open Market Committee typically cuts the Fed Funds rate before recessions begin.
About 1.25% was shaven off of the Federal Funds beginning in December 2000 rate before the recession began in the Spring of 2001. The rate dropped only 1% from July 2007 until December 2007, when the Great Recession began.
Interestingly, though the previous rate cut in July was branded as a "mid-cycle" adjustment reminiscent of 1995 or 1998, in neither case was the Fed Funds rate dropped more than 75 basis points. Thus, if the overnight rate is ultimately dropped by more than 75 basis points, it will be a strong sign of an ensuing recession.
If the Fed drops the Funds rate by 0.25% at each remaining meeting of the year (September, October, and December), then they would have lowered it by the same amount this time around as they did in 2007 before the Great Recession began.
Of course, we did not know that the recession officially began in December 2007 until much later when the data had been revised multiple times. It will probably work out the same in this case.
The trailing twelve month real GDP growth rate ending in the 2nd quarter of 2007 averaged 2.07% per quarter, whereas the growth rate has been higher in the past twelve months at 2.65% per quarter (using chained 2012 dollars).
However, looking at the fall in real GDP prior to recessions is also instructive.
In the four quarters leading up to the recession in the Fall of 1990, real GDP fell by 2.18 points. In the four quarters leading up to the recession in the Spring of 2001, real GDP fell by 4.24 points. In the four quarters leading up to the recession in December 2007, real GDP fell by 62 basis points. In the last four quarters of this year, real GDP has fallen by 92 basis points.
With the trade war unlikely to end anytime soon and manufacturing weakness manifesting in developed nations across the globe, real GDP in the US likely has further to fall, which would be very typical leading up to a recession.
Surprisingly (to me, at least), stocks don't typically drop until very close to, or even after, the beginnings of recessions. The stock market itself, then, is a poor leading indicator.
Three much more historically reliable leading indicators of recession are (1) the 10-year minus 1-month Treasury yield curve, (2) the 10-year minus two-year Treasury yield curve, and (3) the amount that the Federal Funds rate is dropped during cutting cycles.
The first indicator is flashing a red warning sign, while the second and third display yellow "caution" lights.
The trade war, American industrial contraction, debt levels, and global economic weakness should continue weighing on these indicators in the months ahead. In other words, the yield curve should continue to invert, and the Fed will likely continue cutting the overnight rate.
But the main takeaway for me as an investor is that the stock market likely has another year of growth or rangebound movement before the recession manifests and sentiment turns against equities.
Therefore, though I remain overweight defensives and cash, I also remain largely invested in stocks for the time being.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.