The best predictor of a recession is an inverted yield curve.  This is when the yield (rate) on a long-term bond falls below the rate on a short-term treasury.

I have seen different metrics used when determining whether the yield curve has inverted.  I have seen some use the 10-year yield vs. the 2-year yield.  I have seen some use the 30-year yield vs. the 1-month or 3-month yield.

While I pay attention to the 30-year yield, I think it is a little too long of a timeframe to give us what we need in terms of prediction.  If an investor thought we would have a prolonged economic slump for 10 years and then have roaring inflation after that, then it wouldn’t make that much sense to buy and hold a 30-year bond.  It would make more sense to buy a 10-year instrument.

For trading purposes, it might make sense to buy the 30-year bond and then eventually sell it, but only if you think that most others won’t see the inflation coming.

That is my complicated way of saying that I prefer to look at the 10-year yield vs. the 3-month yield when looking for an inversion.  If the 10-year yield falls below that of the 3-month, then you should prepare for a recession, typically within a one-year timeframe.

It is easily forgotten that there was an inverted curve in 2019.  And we did get a recession and major downturn in March 2020.  But the coronavirus and the lockdowns that came with it get all of the blame.  Now we are back into an artificial boom because the Federal Reserve has created ridiculous amounts of new money.

If there was no virus hysteria and lockdowns, it is hard to say how things would have played out.  The Fed would have been forced (politically speaking) to only wildly inflate once things got bad economically.  In March 2020, it had the excuse of the virus and the lockdowns.

If there had been no virus hysteria and lockdowns and the Fed had just done what it did anyway in March 2020, people would have been wondering why the Fed was acting that way even though no crash had happened yet.  We don’t know if this would have been enough to delay any signs of a stock market crash and recession.

Are Bond Investors Telling Us Something?

When people are heavily buying bonds/ treasury bills, it drives down the interest rate or yield.  So if people are rushing in to buy 10-year treasuries, the 10-year yield will go down.  There is a tendency to do this in anticipation of an economic downturn.  Investors are locking in longer-term rates.

The exception to this is when there is anticipation of high price inflation.  You don’t want to get 1.5% per year for 10 years if you think inflation is going to run at 5% per year.  You would be losing money.  The only reason someone would do this is because he sees a loss of approximately 3.5% per year (in real terms) as being better than losing 5% per year.  In other words, you are better off holding the 10-year treasury paying 1.5% per year than having the money sit in a checking account for 10 years earning nothing while losing purchasing power to inflation.

In a relatively non-inflationary environment, U.S. treasury bills and bonds are seen as a safe haven.  When there is fear without a fear of inflation, this is where people put their money.

When you have more demand for long-term government debt and less for short-term government debt, this is a sign of economic problems ahead.  The yield curve tends to invert about 6 months to a year ahead of when the trouble becomes evident.

In the first few months of 2021, the yield on the 10-year was going up.  It was briefly below 1% at the start of the year.  From early March 2021 to early June 2021, the 10-year yield was above 1.5%.

Over the last month, it has started to tick down.  On July 8, it went as low as 1.25% during the day.  This spooked investors in the stock market, which declined that day.

To be sure, the yield curve is still a ways away from inversion.  But it is a little bit closer now than it was a month ago. The bond market is telling us that things may not be so rosy in the future.

The problem is that short-term rates are really low.  They are still near zero, and the Fed isn’t showing signs of raising its target rate, which has a big influence on short-term yields.

Right now, the 3-month yield sits around 0.06%, which is essentially zero.  The only way the Fed is going to hike its target rate this year is if inflation numbers come in really hot.  By this, I mean price inflation.  We already have massive monetary inflation.  And even if high price inflation numbers do come in, the Fed may just not do anything new anyway.

It is going to be very difficult for short-term rates to rise with any significance over the next 6 months, and probably longer.  So to get an inverted yield curve, the 10-year yield is going to have to fall to near zero.  If that happens, we are probably already in a recession, so that isn’t going to do us any good in terms of predictions.

I do think it is possible we could have a recession without an inverted yield curve, especially with the Fed holding short-term rates near zero.

Here is my strategy.  I am prepared for a recession and a stock market crash at any time.  I am not heavily in stocks except for my permanent portfolio and some speculative mining stocks.

But without an inverted yield curve, the prospects for a recession in the coming months is relatively low.  So I am not going to bet on a recession.  For example, I probably won’t be buying any short positions that bet on falling stocks.  I will hedge against a recession, but I will not proactively try to profit from one.

I need to see something close to an inverted yield curve.  Maybe it won’t come before the next recession.  But if that happens, it will be an historical aberration.  There is almost always an inverted yield curve before a recession.