Trying to predict recessions is one of the most popular pastimes in the financial markets. There's a running joke that says certain people have predicted nine of the past five recessions. Fear tends to sell in the financial media, and there's no shortage of people trying to predict the next big crash.
Thankfully, actual recessions are fairly infrequent, but they are difficult to forecast. There are so many variables that go into any one individual economic environment that any one negative catalyst could be offset by another. There's no foolproof method to determine when an economic slowdown is coming. But there is one indicator that, historically at least, has been fairly reliable.
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The 10-year/three-month Treasury yield spread is the signal I'm looking at. These two points on the curve are important for two reasons:
The three-month yield closely tracks the federal funds rate. It essentially reflects what monetary policy is today.
The 10-year yield, on the other hand, reflects the market's expectations for economic growth and inflation over the next decade. It can fluctuate significantly as expectations change over time.
The spread between them almost becomes a bet on the trajectory of Federal Reserve policy rates. Under normal conditions, long-end yields are higher than short-end yields because investors demand higher returns for lending their money over a longer time frame.
When long-term yields fall below short-term yields, there's a pendulum-swing effect in which the market anticipates the Fed will cut interest rates and bring the relationship back to where it traditionally sits.
This is what typically happens when the economy weakens enough to motivate the Fed to cut rates. In a sense, the 10-year/three-month yield spread becomes the market's own recession forecast.
Since the 1960's, the 10-year/three-month Treasury yield spread has turned negative, on average, about six to 12 months prior to the onset of a recession. In most cases, it's flipped from negative to positive right before a recession as well.
This dynamic has preceded the last six U.S. recessions.
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