Why Recession Fears May Have Just Been Renewed

Why Recession Fears May Have Just Been Renewed

Posted On December 15, 2022 1:55 pm

Often, boaters disregard the sound of a foghorn, believing they are a safe distance from danger. However, all captains snap to attention when they hear the scraping of their hull against a reef.

The yield curve is a financial foghorn of sorts. Currently, it is bellowing loud and frequently that the economy is heading towards rocky shoals. Yet, many corporate heads and analysts are maintaining positive earnings growth estimates for 2023. They best be prepared make a dramatic u-turn if…

Similar to the far off sound of a fog horn an inverted yield curve often goes unheeded by investors as they blow well before danger is apparent. As such, many investors are unprepared when problems arise.

Today, the 10-year/3-month US T-Bill yield curve is at its most inverted level since 1982; it now stands at 73 basis points.

An inverted yield curve, whereby the yield of a shorter maturity bond is higher than a longer maturity bond, is an omen that something is wrong. Yield curves are often positively sloped. In free markets, investors should receive a higher yield for taking on the potential risks that grow with time. Since 1986, the 10yr/3m yield curve has been in a state of inversion less than 5% of the time.

The graph below show why an inverted yield curve is a foghorn worth following, even if the current environment doesn’t appear too worrisome.

Since 1986, every yield curve inversion has been followed by a recession. We only show the last four inversions, but be mindful that each of the previous eight inversions led to a recession.

However, and this is a common theme in the following graphs, economic and financial hardship did not occur until after the curve steepened to a positive slope. It has taken anywhere from three to 13 months and .53% to 2% steepening until a recession began.

This means, just when the yield curve starts to normalize causing people believe it’s an all clear single, history has shown it usually means the economy has already drifted into an unavoidable recession.

During yesterday’s post FOMC press conference, Powell made it clear he feels inflation is a worse longer term risk than a recession and seems willing to keep hiking rates until inflation gets back to the 2% target level.

It looks like 2023 is going to bring some rough seas. You’ve been warned…

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About author

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.