Recession Prediction: Are Bonds a Warning Sign?

Posted On March 27, 2018 2:19 pm

While corporations, consumers and the stock market have mostly cheered Trump’s deregulation and tax policy as being a boon to the economy, the bond market’s reaction has raised concerns we might actually be heading towards a crisis in 2018. Today we’ll explore the basis for this recession prediction.

Economists have been pointing to the flattening yield curve. That is, the narrowing of the spread between short and long dated bonds, as a warning sign that economic growth might be flagging.  A flattening or inverted yield curve has preceded every recession since 1955.

Indeed, even as the Federal Reserve has raised the Fed Funds Rate four times over the past year, the long-awaited repricing of the U.S. bond market has stalled once again.

While those short-term rates have risen by 120 basis points it now stands at 1.75%, the yield 10-year Treasury Note has climbed only about 50 a basis points and has been bound in the 2.75%- to 2.90% range for most of 2018.

The most closely monitored spread is between the and 2 and 10-year notes. Here, one can see the dramatic narrowing or flattening of the past year.

And the new Fed Chairman Jerome Powell shown his desire to ‘normalize rates’ and indicated that, baring dramatic change in economic data, he will rise rates an additional three times in 2018.

This comes as a result of Powell’s concern over inflation, which would eat away at the value of longer terms causing their yields to rise.

But so far, the increase in yields has mostly occurred on the short end of the curve.

The good news is the yield curve, while flattening, remains far from inverted.  According to fresh research by the Federal Reserve Bank of San Francisco, inverted yield curve remains a powerful symptom a looming recession, and that is still the case even if the current ultra-low level of U.S. interest rates are taken into account.

In the coming weeks, we’ll keep an eye on some of the key data points such as employment, inflation and consumer spending for clues to where the yield curve and, in turn the economy, might be heading.

In addition, we’ll try to identify potential trades for both protecting against and profiting from a possible recession.

 Related: Learn the Surprising Truth Behind the Market Recovery

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Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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