Four Economic Indicators Pointing to Recession
Some of you may be wondering why there’s so much talk of US recession when the stock market is trading close to its all-time highs and unemployment is at historic lows. In the following article, we’ll take you through a number of indicators that are pointing towards recession.
Back in August of this year, Google searches for the word “recession” more than tripled worldwide and quadrupled in the US. As the screenshots below show, the last time searches for this term were anywhere near this high was back in 2008, ground zero for the last financial crisis, or “the great recession” as it has been dubbed.
So, what was it that prompted people all over the world to start searching for recession? This takes us to our first big recession indicator.
1. Yield Curve Inversion
Most people have no idea what the yield curve is or why it’s important and you can’t blame them. It’s not an instrument they ever really have to deal with like foreign exchange or stocks. The yield curve describes the interest rate paid on government bonds with different maturities, also known as Treasuries or T-bills.
A bond is a fixed income security that matures on a given date. You purchase it, it pays you interest until that maturity date, at which point you also receive your initial sum. In other words, in the case of government bonds, the yield curve describes how much it costs the US government to borrow money for different durations. Bonds come in a variety of maturities and pay different interest rates according to how far off the maturity date is.
Now, under normal conditions you would expect a bond with a longer maturity to offer a higher interest rate. This makes intuitive sense. The longer you have to lock up your money, the higher the return you would naturally expect.
Back in March the yield curve inverted for the first time. In other words, a shorter term bond (in this case the 3-month) yielded more in interest than the 10-year. Markets took note of this, then in May it inverted again and has remained inverted ever since.
The most closely watched yield spread is between 2-year and 10-year treasuries. In August, 2-year and 10-year yields also inverted. That was when “recession” suddenly became a highly trending search term. Why is this important? The 2-year/10-year yield curve inverting has preceded every recession since WWII.
2. New York Fed Recession Indicator
This brings us neatly on to our second indicator. The New York Fed publishes its own recession indicator that uses data from the spread between the 3-month and 10-year bond rate to predict the probability of a recession occurring within the next 12 months. In August their indicator registered a 40% probability of a recession taking place before the end of next summer. It’s currently sitting at 37.93%.
Their indicator has been continually published for as long as there has been a New York Fed and, as you can see below, it has a pretty good record of predicting recessions. Why is this indicator important? The last seven US recessions hit at most 13 months after the 3-month/10-year yield curve inverted.
3. Unemployment as a (very) lagging indicator
Even though daytraders follow the labor market closely and tend to generate a great deal of volatility around unemployment rate and non-farm payroll data, employment is considered a lagging indicator. With lagging indicators, the change is registered long after the conditions that set it in motion within the economy actually took place.
According to legendary investor Gary Shilling, in the 11 post-war recessions that the United States has experienced, the average lag between the peak in the business cycle and the lows in the unemployment rate is 17 months.
So, it takes 17 months after we reach a peak in business for unemployment to reach its lows. In other words, when the media is raving about record low unemployment levels we’re almost a year and a half after the peak in the economy.
Those of you who follow the financial news will remember this headline or one like it. Earlier this month US markets received a boost of confidence when the unemployment rate was shown to have fallen to 50-year lows. What does this tell you? It should tell you that the unemployment rate can indeed continue to decline, even after you have entered into a recession.
4. Revisions: when every indicator is a lagging indicator
If all of the above isn’t enough to get you on the phone to your nearest gold broker, then it’s time we had a little talk about economic data revisions. Most people who follow economic indicators like GDP, unemployment and consumer confidence don’t check back after the data is released to see whether it was revised.
Revisions routinely take place as further data is accumulated, which means that the figures you thought you were trading on weren’t actually the real figures at all. In a bull market usually economic data is revised up as evidence arises to show that the situation is better than expected.
In a downturn though, economic data tends to be revised down. In other words, the picture is worse than we initially thought. It really means that essentially all economic indicators are lagging, especially at the extremes. What have we had this year? A slew of downward revisions showing a worsening US economy, after the data has been released, digested and priced into the market.
As far back as last year, we’re seeing revisions that show the situation wasn’t as rosy as we thought at the time. US GDP data from Q4 2018 was revised down from president Trump’s stated target of 3%, to 2.5% recently.
In fact, all you need to do is Google “revised down” (with the quotation marks) and scroll down through the pages to witness the alarming regularity with which economic data is quietly revised down after the fact while the markets are busy awaiting the next release. The point? When a large number of data points are subsequently being revised down, it’s a pretty powerful indication that the downturn has arrived and it’s just the data collection that hasn’t yet caught up.
Many recession indicators are lining up to suggest that perhaps the clock is ticking on a US recession. Of course, this doesn’t guarantee anything. Not every recession warning comes to pass. The real worry here is that the US, on the surface at least, seems to be the strongest economy of the bunch.
It has managed to tighten its monetary policy (whether it has over-tightened or not is a debate for another time) and its interest rates are higher than the rest of the world. This means that the Fed has a lot more tools in its box to manage a crisis.
The fear is that if the pick of the bunch falters, what kind of a knock-on effect will this have on the rest of the world, particularly Europe, which is looking a lot more fragile at the moment?
Disclaimer: This article is not investment advice or an investment recommendation and should not be considered as such. The information above is not an invitation to trade and it does not guarantee or predict future performance. The investor is solely responsible for the risk of their decisions. The analysis and commentary presented do not include any consideration of your personal investment objectives, financial circumstances or needs.