I have been paying closer attention to the yield curve than anything else at this point.  The policy of the Federal Reserve has been tight for several years now, at least in the fact that it hasn’t been creating new money and, more recently, rolling off a relatively small amount of maturing debt.

The stock market is obviously indicating a boom, but stock investors are unreliable in terms of predicting the future.  A stock boom can turn into a crash really quickly.  The only warning sign is an uptick in volatility, which we have seen this year.

Bond investors tend to be better forecasters as a collective.  And by far the most accurate predictor of a coming recession is an inverted yield curve.

Over the last year or so, short-term interest rates have come up after being near zero for many years.  Long-term rates have also risen, but to a lesser degree.  This has led to a flattening yield curve, but it is not yet inverted.

I tend to compare the 3-month yield against the 10-year yield, but other people will focus on different maturity lengths.

With that said, it is interesting to just take a look at the 5-year yield against the 10-year yield.  As of the close on July 13, 2018, the 5-year yield stood at 2.73%, while the 10-year yield stood at 2.83%.  This is a difference of just 0.10%.

This differential is almost nothing, yet the difference is a maturity length of five years.  You can lock in a rate for 10 years at 2.83%.  But for an annual return of 0.10% less (almost nothing), you only have to lock in for 5 years.  If someone buys a 10-year bond, then he is expecting the rate to be lower in 5 years than what it is now, or at least he is expecting most everyone else to expect this (if that makes sense).

This means that the overall market sentiment is that price inflation will remain relatively low.  With U.S. bonds, there is almost no chance of an actual default (not counting the partial default from possible inflation).  Therefore, the interest rate doesn’t vary between maturity lengths due to a default risk.

If bond investors are suggesting that interest rates will be lower in 5 years than what they are now, then this means we are likely to have a significant economic downturn between now and then.  And with this downturn, there are not big expectations for price inflation.

This doesn’t mean that bond investors (as a collective) are correct.  But at the same time, I tend to trust bond investors more than stock investors.

I will continue to watch the yield curve closely.  Once it is flat or inverted, it means you should prepare rapidly for a recession.

I recommend that you prepare for a recession anyway.  This means having backup plans for your source of income.  This means not being heavy in stocks.  This means having liquidity.

If you have a strong cash position with little or no debt entering into a recession, then you will be so much better off than most others.  Not only will you be able to meet your monthly obligations, but you can actually take advantage of discounts in asset prices for assets that are heavily sold off during the downturn.

In the meantime, take advantage of the higher short-term rates with your cash position.  You can find a financial institution that pays a decent rate, or you can consider opening a TreasuryDirect account.  You probably aren’t going to regret having too strong of a cash (or cash equivalents) position.