The most accurate sign of a coming recession is not what you think it is - and it's on the verge of flashing
- The inverted yield curve is a closely followed recession indicator, but it isn't the only one to watch.
- Prior inversions have preceded a recession by as much as two years, making it difficult to use as an accurate gauge.
- It's the re-steepening of the yield curve, or de-inversion, that's more closely followed by a recession.
Investors love to point to an inverted yield curve as a surefire signal that the economy is about to hit a recession.
That's because since 1960, every time the 10-year and 2-year US Treasury yield curve inverted, which happens when short-term bonds offer a greater return than long-term bonds, a recession has followed.
But the closely watched signal is a poor market timing tool because prior inversions have preceded a recession by as long as two years. And within those two years, stocks, in some instances, performed well.
There's another signal investors should pay close attention to that has historically signaled a recession is right around the corner rather than years away.
That sign is the re-steepening of the yield curve, or when short- and long-term bonds flip back to the usual setup of higher yields for longer-term maturities.
"When the yield curve un-inverts, it is signaling that the recession is closer (within one year based on the past three recessions). While the inversion says trouble is coming in the medium term, the un-inversion says trouble is coming within a year," Commonwealth CIO Brad McMillan said.
Since the yield curve went negative in July amid aggressive interest rate hikes from the Federal Reserve, it didn't look back, at least until this past week.
The 10-year and 2-year yield curve was inverted by more than 1% on March 7, the steepest inversion since the 1980s. But the fallout from the collapse of Silicon Valley Bank has led to a sharp decline in interest rates and drove the fastest three-day re-steepening of the yield curve since 1982, according to Bank of America.
The yield curve more than halved its negative inversion to negative 42 basis points this week, and if the Fed pauses its interest rate hikes and short-term yields continue to fall, a complete un-inversion of the yield curve would be imminent, signaling that a recession is close at hand.
"Yield curve always steepens into recession," Bank of America's Michael Hartnett said in a Friday note.
That lines up with the thinking of CIBC Private Wealth's chief investment officer David Donabedian, who told Insider that "in light of the banking crisis, our view is that a recession is even more likely, and might be pulled forward. A decline in risk taking and credit extension as a result of the banking crisis is ahead."
But others are less bearish on the prospects of an de-inversion of the yield curve and potential recession, including Commonwealth Financial Network's head of portfolio management, Peter Essele.
"Even though the signal is concerning, it's not quite time to hit the pause button on equities. Late-stage economic cycles often produce robust returns for investors. It's not until the yield curve fully un-inverts that forward returns become a concern. Therefore, we caution against selling out of risk assets at this time," Essele told Insider.
That thinking echoes what Fundstrat's Tom Lee told clients in a webinar on Thursday.
"I think inflation is broken, that's why the yield curve is un-inverting. But we really haven't yet broken the economy."
While the yield curve has yet to fully un-invert, it's heading in that direction after this week's banking crisis, and when it does, investors should be prepared for a potential recession and poor equity returns.
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