Recession fears are back in vogue as the world economy faces a plethora of serious challenges. China’s zero-Covid policy is spectacularly failing, bringing its economy down with it with every new lockdown. The resulting disruption of supply chains reverberates globally from Europe to Australia and Africa. Inflation is at its highest in 40 years and central banks are rushing to raise rates in an attempt to tame it. And if that is not enough, the war in Ukraine is hanging like the Sword of Damocles over much more than just the economic recovery. No wonder Wall Street economists and analysts predict a recession in 2023.
While we agree things have not been this bad in decades, we only have one question: why would a recession wait till 2023? We believe the US and maybe even the global economy is in one already. After all, US GDP growth came in at -1.4% in the first quarter of 2021. In order for economists to formally recognize a recession they need at least two consecutive quarters of negative GDP growth. This means a recession might be in progress already, but economists would not know it until Q2 data are out in late-July. And the recession might as well be over by then anyway so why bother?
So instead of waiting for the next GDP reading, we’ve found another reliable indicator in the face of the 10-year minus 3-month Treasury yield spread. Take a look at it below.
This chart shows how the 10-year-3-month Treasury yield spread has narrowed and widened over the past 40 years. As visible, every time the spread falls below 0%, a recession (shaded area) follows soon enough. What interests us more, however, is that a recession doesn’t begin immediately after the yield curve inverts. Instead, the economy does just fine for a year or two until the yield curve un-inverts and starts steepening again. Once the spread approaches 2%, that’s when you should be most worried as that’s when a recession usually begins. At yesterday’s market close, the spread stood at 2.27%.
To sum up, we’ve already formally recorded one quarter of negative GDP growth. Inflation is at its highest level in over four decades. Food and energy prices have gone through the roof, because of Russia’s invasion of Ukraine. China, the factory of the world, is interrupted by Covid-19 lockdowns and restrictions. And the yield curve spread cycle is at a phase which usually coincides with recessions.
Yet, Wall Street economists want us to believe the economy won’t notice until 2023. We respectfully disagree. Furthermore, the stock market is known to anticipate economic downturns. It usually starts falling months before the data confirm something’s wrong with the economy. Year-to-date, the S&P 500 is down 13.5%, NASDAQ has tumbled 22.4% and the global MSCI ACWI index has lost over 14%. Maybe the market already knows something economists have yet to find out?
The good news is the economy exits recessions and starts recovering roughly when the 10-year minus 3-month yield spread approaches 4%. Currently at ~2.30%, we’re more than halfway there already. It is likely to get worse before it gets better, though, so fasten your seatbelts.
