SCREAMING: Keep Your Eye on This Indicator!

RECESSION SIGNAL SCREAMING: Keep Your Eye on This Indicator!

With the stock market rising in anticipation of interest rate cuts this year – which Federal Reserve Chairman Jerome Powell specifically said he didn’t expect to happen – sensible investors need to be on recession watch. There are plenty of glaring red flags, but one particular yield spread (not just the 2-year and 10-year Treasury yield spread) is signaling an imminent contraction of the U.S. economy.

Remember, the current crisis in the banking sector will have ripple effects for the remainder of 2023 at the very least. The U.S. economy depends on access to credit; without lending activity, businesses can’t be started and maintained. Moreover, people typically can’t buy a car or home without access to loans.

This wasn’t a problem when the Fed kept interest rates at 1% or 2%. After inflation was factored in, the “real” interest rate was effectively zero. Easy credit conditions prevailed from 2009 through the COVID-19 crisis until the inevitable inflation fiasco (which I warned about multiple times) prompted the Federal Reserve to overreact with a series of huge interest rate hikes.

In 2023, unusually high interest rates on government bonds mean that the prices of those bonds have cratered. Banks of all sizes invested in those bonds, and now the net worth of those banks has diminished drastically because the value of those bonds has dropped – hence the enormous stress on the those that precipitated the collapse of Silicon Valley Bank, Signature Bank, and others (expect many more this year).

The ripple effects don’t only apply to banks, either. Watch for auto loans to nosedive in the coming months as Powell continues to raise interest rates. The automotive industry, already pressured by persistently high inflation, will be on the brink of collapse this year as auto credit availability is rapidly tightening.

In the automotive market and elsewhere, prepare for credit conditions to become increasingly restrictive and business activity to slow down to a crawl. This alone is a clear-cut recession warning signal that the stock market is conveniently ignoring at the moment.

Powell himself warned that a significant number of FOMC officials “expect credit tightening” following the recent bank failures. This occurred while Credit Suisse, a banking giant in Switzerland, was bought out by UBS for pennies on the dollar.

Banks tightening their lending standards will undoubtedly increase the default rate on a broad variety of loans. These will include not only auto loans but consumer loans of all types from credit cards to home loans and the “buy now, pay later” financing programs that are so popular today.

Other recession indicators include the multiplicity of bond yield inversions, the most commonly monitored one being the spread between the 2-year and the 10-year Treasury bond yields. Going back to the beginning of the millennium at least, whenever the short-dated bond yields are higher than the long-dated ones, investors should be on recession watch. Then, when the yield curve steepens (which is happening now), a financial contraction is likely imminent.

In effect, yield curve inversions mean that the bond market expects interest rate cuts to happen soon (again, the Fed Chairman himself indicated otherwise). And they only anticipate rate cuts because they believe this will be the central bank’s response to an economy that’s imploding.

Don’t expect the Fed to “save” the economy and markets since Fed officials are singularly focused on doing whatever it takes to bring inflation to 2% – and we’re still nowhere near that. Before they actually pivot to interest rate cuts, they’ll want to see things breaking in the economy; not just a few small banks failing but real breakage in the form of higher unemployment, a slowdown in business activity, and so on.

Then there’s this recession indicator that hardly anyone is watching but has been consistently spot-on since the start of the millennium. As a result of tightening credit, the spread between the yields on high-yield debt (such as junk bonds) and investment-grade debt is widening.

This yield spread reached 367 basis points this month. For comparison, this same yield differential reached 354 basis points in December 2007 and 276 basis points in February 2020 – and recessions and market crashes happened soon afterward in both instances.

Like the steepening of the 2-year and 10-year Treasury yield spread, the increase in the spread between high-yield debt and investment-grade debt isn’t the cause of an economic contraction. It’s an indicator of dislocations in financial conditions that signal problems ahead. How you choose to interpret this – and whether you turn a blind eye to it like most people will or respond appropriately – is entirely in your hands.