Financial markets freaked out on Aug. 14, when the interest rate on 2-year Treasury securities temporarily fell below the rate on 10-year notes. Long-term rates are normally higher than short-term ones, and when these rates “invert,” it often means a recession is coming. Stocks fell 3% that day.
But everything’s fine now! Stocks recovered and are close to new record highs. President Trump even suggested his critics are trying to talk people into thinking there’s a recession, to torpedo his 2020 reelection bid.
So what are ordinary people supposed to think? Is a recession coming or not? It’s actually extremely hard to predict. But there are a series of warning signs that normally flare as a recession is forming, and some of them have begun to light up.
Measuring the yield curve
The inverted yield curve has a strong record of foretelling a recession. But it’s a long-lead indicator, and different ways of measuring the yield curve are saying different things. The gap between 2-year and 10-year rates is now positive once again, for instance, suggesting no recession is coming.
But the gap between 3-month and 10-year rates has been negative since late May. And that gap has been a “remarkably good recession predictor,” according to research firm Capital Economics. A 3-month/10-year inversion has occurred before 6 of the 7 recessions we’ve had since 1970, with no false positives. It did not invert before the 1990 recession, but came close.
This warning sign flares 12 months before a recession actually begins, on average. If that were to hold this time around, it would suggest the onset of a recession around the middle of 2020. Economists are skeptical, however, partly because interest rates are far lower than historical norms, which may distort their predictive ability.
Another piece of data, the Conference Board’s index of leading economic indicators, is designed to predict turns in the economy—with a strong record of doing so. Capital Economics found that a recession developed every time the LEI, as it’s known, fell by 2% or more, on a year-over-year basis. But the LEI only predicted the onset of recession about a month ahead of time. It’s not at recession levels now, but it could get there in a fairly short period of time.
Other signals are less reliable. A measure of new orders in manufacturing, for instance, is now at levels that sometimes suggest a recession is imminent. But that gauge has hit similar worry levels several times in recent years, with no recession coming. Then it recovered.
When people start to notice
As for the warning signs most people tend to notice in their everyday lives, those usually occur very close to the beginning of a recession, or even after it has started. The unemployment rate, for example, typically hits a cyclical low right before a recession begins. By the time widespread layoffs kick in and everybody knows there’s a problem, the recession is typically on.
The New York Federal Reserve puts the odds of a recession within the next 12 months at 38% – and that has risen rapidly in 2019. But that’s based on the gap in interest rates, so if rate spreads are less predictive than they used to be, the New York Fed would be overstating the risk.
Capital Economics puts its own estimate of a recession at 20% within the next year, a forecast also dependent on interest rate spreads. Those odds might sound low, but they’re not, because of the 12-month time lag. In fact, a recession occurred within 12 months every time the Capital Economics odds hit 20% or more, with the exception of the mid-1960s.
The takeaway for consumers is that we’re almost certainly not in a recession now. But the outlook could darken in coming months. The thing to watch for isn’t any single indicator, but a variety of reliable indicators, if they begin to say the same thing.
President Trump has a role to play, through trade policy that could either hasten the onset of a recession of give the economy a fresh boost. Then there’s the Federal Reserve, which may cut interest rates in the hope of keeping the expansion going. No recession is inevitable, but it would help if influential policymakers got their part right.
Rick Newman is the author of four books, including “Rebounders: How Winners Pivot from Setback to Success.” Follow him on Twitter: @rickjnewman