How to Predict a Recession. Accurately.

I’m often asked if there’s a good way to know if a recession is coming. The answer is yes, there is!  Really!

Below, I’ll share a fairly accurate method of predicting recessions! You can amaze friends at your next party! But first, why is this important? Why should you care?

Simply because an economic downturn affects everyone. Badly:

• Business Owners/Employers: A decline in economic activity typically means your top-line revenue will decline in the immediate future – usually for about the duration of the recession plus a year or so after, depending on your business.  Sales will slide; margins, decline.

• Job Holders/Employees: Recessions are not your friend. As businesses shed revenue, they also tend to lay off workers. Quoting the Federal Reserve bank of Cleveland, “Historically, unemployment has always increased whenever the aggregate economy experienced a recession. But the rate typically peaks about 15 months after the beginning of the recession, or 4 months after the end of the recession, and then starts to drop gradually over time as the economy recovers….”

Clearly, no one wins when a recession hits. How long do recessions typically last?

Since 1854, our ‘National Bureau of Economic Research’ has tracked recession data, and per the NBER the good news is that the prior 10 recessions (since 1945 and excluding the “Great Recession of 2008”) lasted only an average of 10 months. Recession duration is shrinking. Good.

OK…so how can we predict the next one?

Simple: Keep an eye on the US yield curve. More specifically, the difference between the 10-year Treasury note and the 3-month Treasury bill.

Visually, watch the steepness of the curve. The steeper the curve (meaning the lower the 3-month and the higher the 10-year) the lower the probability of a recession.

Imagine you draw a typical X-Y graph. One vertical line and one horizontal line. Now, right below the left end of the horizontal line, write the 3-month yield. Directly below the right end, the 10-year rate. Now, above each, place a dot for the numeric value of the yield – at the height appropriate for the yield. Say the 3-month is .33% and the 10-year was 1.76% – just like it was on 2/26/16. Now, draw a line between the two dots. You have a line that is lower on the left and higher on the right, correct? This is a typical, healthy yield curve.  No recession any time soon.  Note that the ‘difference’ between the two yields is, at present, is 1.43%.  Good.

If, or when, the yield curve becomes ‘inverted’ – meaning the 3-month yields are higher than the 10-year yields, the probability of a recession has increased. And when the inversion gets really large (meaning the left side of the line is a lot higher than the right side), a recession almost always comes within the next 2 or 3 calendar quarters.

Economists have studied this topic for decades. In 1996 Arturo Estrella and Frederic Mishkin, two economists at the New York FED, wrote a paper called “The Yield Curve as a Predictor of U.S. Recessions.” It’s a great discussion of the topic. Here’s the URL: https://www.newyorkfed.org/medialibrary/media/research/current_issues/ci2-7.pdf

Their findings: When the spread is greater than 1.21%, recession probability is less than 5%. When the spread goes negative (meaning the 3-month yield is greater than the 10-year yield) by (.82%), the probability is about 50/50. And when the negative spread reaches (2.4%), the probability is 90% we’ll see a recession soon.

Interesting, right?

So, keep an eye on just these two yields. It’s that simple. The 3-month and the 10-year. Subtract the 3-month from the 10-year. If the number is positive, there is no recession in sight. We’re good. Do this every few weeks. Keep an eye on the trend.

If the number goes negative, however…hmmm, Houston we have a problem.