Last week, stock markets finally freaked out about the possibility of a recession in the US. Bond markets have witnessed declining yields and a flattening yield curve for weeks, but stock markets kept their cool. Until the US Treasury yield curve inverted for the first time since 2007. Of course, investors have been debating yield curve inversions all year since different parts of the yield curve have inverted before, but last week, we saw the spread between 10-year and 2-year Treasury yields finally turn negative. As I said before, the 10Y-2Y yield spread is my preferred measure for yield curve inversions because it tends to be the most reliable one with few false alarms.
However, the eternally bullish society of fund managers keeps arguing that it won’t be as bad as everyone thinks. According to the latest Bank of America Merrill Lynch fund manager survey, the share of fund managers who expect a recession in the US in the next 12 moths may be at the highest level since 2011, but 64% of fund managers still don’t expect a recession. That is two out of three fund managers are busy explaining away the inverted yield curve as a recession indicator. I guess, if you run a fund, you better be eternally bullish. It’s called talking your book.
In any case, there are by now several indicators that historically have “predicted” a recession more or less accurately. Of course, for every single indicator one might find good reasons why this one might not be reliable today, but if you are faced with several different indicators signaling a recession, then things get a bit more difficult.
Thus, I have looked at nine different indicators that are often quoted in the media as recession predictors and checked if they currently signal a recession:
The yield spread between 10-year and 2-year Treasuries. If it is negative, I count it as an indicator that signals a recession in the next 12 months.
The Federal Reserve is cutting interest rates. If this is the case, I count it as an indicator that signals a recession in the next 12 months.
The ISM Manufacturing Index. If it drops below 50 points, I count it as an indicator that signals a recession in the next 12 months.
Quarterly GDP growth. If we get one quarter of negative growth, I count it as an indicator that signals a recession in the next 12 months.
Nonfarm payrolls. If the average number of new jobs over the last three months is below the average number of the previous three months, I consider it a recession signal. The three-month averages are used to smooth out any outliers that may appear in any given month.
Existing and new home sales. If the three-month average is below the average of the previous three months, I consider it a recession signal.
The recession probability for the next twelve months calculated by the New York Fed and the Cleveland Fed based on two different methodologies. If the recession probability rises above 30%, I consider it a recession signal. The level of 30% is used, because historically, almost every time these indicators climbed above 30% they continued towards 50% and a recession followed. However, in some cases (e.g. the recession of 2001) these indicators never even reached 50% probability.
In total this provides me with nine different indicators that may signal a recession. You can argue with every single one of these indicators but if many of them trigger a recession warning at the same time, you can be reasonably sure that there is something going on.
The chart below shows the number of signals that triggered a recession warning (blue line) together with the official US recessions (grey bars) over the last 40 years. Even though I use nine different indicators, at no point did all indicators signal a recession at the same time. The best we can hope for is six out of nine.
Within the last three weeks the number of indicators signaling a recession has jumped from three to five, thanks to the Fed starting to cut interest rates and the yield curve inverting. With one exception, whenever the signal count was at five or higher in the last 40 years, the US was either already in recession or dropped into recession in the next 12 months. The only exception was April 2003, when the signal count briefly jumped to five before dropping immediately back to four.
And while that proves nothing, it clearly shows that the likelihood of a recession in the US in the next 12 months is very high. The plot thickens…
Number of indicators signaling a recession in the US
Source: Fred, St. Louis Fed.