Chicken Little and the economy: How many falling acorns signal a recession?

Business News | 15 Apr |

Chicken Little would have been a terrible economist. She was hit on the head by a falling acorn and immediately declared “the sky is falling.” Perhaps a bit more analysis should have been conducted since the sky, in fact, was not falling.

Just like Chicken Little, the bond market was recently hit on the head with an acorn, and the yield curve screamed “recession.”  The yield curve temporarily inverted, and the three-month Treasury yield was higher than the 10-year yield. This created a bit of hysteria because an inverted yield curve has predicted the last seven recessions since 1970 with only one head fake.

However, just as one falling acorn does not ensure the sky is falling, an inverted yield curve alone does not suggest a recession is imminent.

The Yield Curve Is Not All-Predicting

The slope of the yield curve has been a good recession indicator, but it’s not the only recession indicator. As the economy slows and inflation expectations wain, the yield of shorter-term bonds can be higher than longer-term bonds, the yield curve becomes inverted, signaling a looming recession. Historically the indicator has been the two-year to 10-year Treasury slope. In late March, the three-month to 10-year slope inverted for only one week. And, the two-year to 10-year slope never inverted.

We suggest investors don’t look at just one flavor of inversion, but rather seek out confirmation. In the past two cycles the two-year to 10-year slope inverted first, then a few weeks later the three-month to 10-year slope inverted providing confirmation.

Recession Indicators Beyond the Yield Curve

One falling acorn does not verify the sky is falling. The same is valid for economic forecasting. Looking at one economic variable mutually exclusively will in most cases provide an inaccurate “the sky is falling” forecast. We prefer to analyze numerous data points to confirm a signal and reduce the noise that can lead to untimely portfolio management decisions.

The slope of the yield curve is a good recession indicator sooner or later. However, it has been a less than timely guide to asset allocation. Since 1968 the yield curve inverted an average of 12 months prior to a recession and six months before the S&P 500 peaked. How do we get confirmation?

The Conference Board’s leading Economic Index (LEI) has a similar track record in predicting recessions. LEI is an index of 10 leading economic variables. Over the past 50 years it tends to be timelier than the slope of the yield curve. Again, since 1968, LEI has sounded the recession alarm five months after the yield curve inverts, giving us confirmation. High-yield bonds also provide clues to oncoming recessions. High-yield spreads, the difference between the yield of a low-quality bond (junk) and a Treasury, typically expand significantly after a yield curve inversion and before the stock market peaks. Lastly, we like to look at the Fed Funds rate and compare it to the neutral rate. The neutral rate is the Federal Reserve’s estimate of the optimal short-term rate that will keep the economy in perfect balance. Historically, recessions only occurred when the Fed Funds rate is meaningfully above the neutral rate for an extended period. The Fed currently estimates that the neutral rate is 2.80 percent. Since January, the Fed has been signaling that the Fed Funds rate will remain at 2.50 percent for the foreseeable future and recently pledged to keep it unchanged well into next year. 

A Case Study: The Great Recession’s Timeline

So, what was the progression of these variables before the last recession?

• Inverted yield curve: The two-year to 10-year slope inverted in December 2005, and the three-month to 10-year slope inverted in June of 2006. This was 16 months before the peak in the stock market and the onset of the Great Recession. It was a very early signal last time.

• LEI: This indicator crossed into negative territory in August of 2006, nine months after the yield curve inverted, yet 14 months before the stock market peak and 16 months before the recession officially started in December 2007.

• High-yield spread: The junk bond market experienced its first round of meaningful spread widening in early 2007, which culminated in July of 2007, only three months before the stock market peak.

• Fed Funds above the neutral rate: This first occurred during the fourth quarter of 2005 (causing the inversion of the Treasury market discussed above). Fed Funds had moved more than 2 percent above the neutral rate by late 2006 and more than 18 months ahead of the slowdown in the markets and economy.

All four of these important signals fell into alignment over an 18-month period (late 2005 to mid-2007), and three had been triggered at least a year before the stock market peak and the onset of the Great Recession.

Is the Sky Falling?

Today, our checklist shows that so far only one signal has flashed (Treasury inversion), and it failed to hold:

• The Treasury yield curve: Inverted briefly, but is now positively sloped.

• LEI softening: The six-month rate of change needs to be at -3 before we declare the sky is falling. The rate of change is at zero.

• High-yield: Spreads moved very slightly higher for a moment in March when the yield curve inverted, but are now even lower than before that event.

• Fed Funds: Roughly 35 basis points below the neutral rate.

The moral of the story is that you need more than one acorn to hit the economy on the head before investors declare the sky is falling and a recession is looming.

 

KC Mathews is the chief investment officer at UMB Bank.

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