The best indicator for a recession is an inverted yield curve. This is when yields (interest rates) on longer-term debt go below the yield for shorter-term debt.
I have seen different people use different benchmarks. For example, one person may use the 30-year yield up against the 1-year yield. If the 30-year rate falls below the 1-year rate, then this is a recession indicator.
Personally, I like to use the 10-year yield on U.S. Treasuries against the 3-month yield. The 10-year yield has a high correlation with 30-year fixed mortgage rates in the United States. If the 3-month yield goes above the 10-year, then this is a clear recession indicator, and you should hold on tight.
I would like to point out just how fast the yield curve can flatten at this point. For me, a flat yield curve is practically as good as an inverted one. A flat yield curve would indicate long-term yields and short-term yields being approximately equal.
On May 29, 2018, stocks tumbled (and the U.S. dollar rose) on news of political happenings in Italy. There is growing fear that Italy could default on its debt and/ or break away from the European Union. There is also possible major trouble in terms of the banking and financial system.
Take a look at the yields on 05/29/18 as compared to 05/25/18 (05/28/18 was a holiday). The 1-month yield jumped from 1.70 percent to 1.77 percent. The 3-month yield went from 1.90 to 1.93. Meanwhile, the 10-year yield plummeted from 2.93 to 2.77. This was just over a week after the 10-year had hit 3.11.
On 05/30/18, stocks recovered and had a big day. The 10-year yield rose to 2.84, so it did not go back to the level seen from 05/25/18. But the 1-month yield stayed the same from the day before, which meant it was still considerably higher from 05/25/18. The 3-month yield went up slightly again on 05/30/18 to 1.94.
In other words, the longer-term yields went down over this period (2 business days), while the shorter-term yields went up.
(If you click on the Treasury site after May 31, 2018, you will have to select the 2018 time period to view May.)
As of this writing, the 10-year yield is only about 90 basis points higher than the 3-month yield (2.84 vs. 1.94). In other words, the yield curve has flattened a bit, and it happened rather quickly.
There aren’t many things in life that are this useful in making predictions, especially when it comes to the world of economics and finance. But an inverted yield curve is almost a sure thing that a recession is coming. In some cases, the recession may already be there, but people just don’t know it yet.
It is telling that we really would just need a few weeks of this kind of turmoil before seeing a flat yield curve. I am not saying this will happen in the near future, but just that it is looking more and more feasible.
When short-term rates were near zero, I wasn’t sure what to make of it. I said that perhaps a recession was still possible without an inverted yield curve because short-term rates were near zero. It would be impossible to invert unless long-term rates went to zero or negative.
But now, short-term yields are considerably higher than they were. The 1-month and 3-month yields are the only ones that haven’t hit the 2% mark, but they are really close. All of a sudden, an inverted yield curve looks a lot more likely.
This is something I will continue to watch closely, as all other economic analysis combined probably can’t match the power of this one indicator. When a recession is about to hit, it helps to know the approximate timing.