The yield curve is widely regarded as a reliable predictor of a recession, and it has been suggesting that a recession may be on the horizon since mid-2022. However, the S&P 500 has shown a significant increase from its lows in October of last year and is currently only slightly below year-to-date highs, which appears to contradict concerns about a recession. Nevertheless, the fixed income markets are anticipating that the Federal Reserve may cut interest rates by the summer, potentially as a response to a recession in the United States.
The Evidence From The Bond Markets
The inverted yield curve is considered to be one of the most reliable recession indicators, and it has been consistently in effect since July 2022, with the 10-year Treasury yield remaining below the 2-year yield. In fact, it has been shown to be more reliable than other leading indicators. Furthermore, there is a high probability of almost 90% that the Federal Reserve will cut rates by September 2023, as suggested by fixed income markets, despite the Fed’s repeated statements that such a move is not in their current forecast. However, the possibility of a recession could prompt such an action.
The Stock Market
The stock market appears to be more optimistic, with the S&P 500 up 7% year-to-date and not as concerned about the economy. Despite recent banking issues, tech stocks have rallied, while more defensive sectors such as healthcare, utilities, and consumer goods have lagged in 2023. Although the stock market is considered a leading indicator of the business cycle, it is possible that stocks see a recession but are looking past it to future growth, taking into account lower discount rates that a recession may bring as interest rates decline. Additionally, since the U.S. stock market is relatively global, the fate of the U.S. economy is a significant factor in driving profits but not the sole factor.
It will be crucial to keep track of unemployment data as a potential indicator of an upcoming recession. Although the yield curve is a reliable long-term predictor of recessions, it is not as precise in determining the exact start of a recession. Monitoring unemployment rates can provide a more accurate timeline. While the unemployment rate rose slightly in February, there have been similar spikes in the past that proved to be false alarms. However, if we see a sustained increase in unemployment from the low levels of 2022, it may be a clear signal that a recession has arrived.
Economist Claudia Sahm suggests that a sustained 0.5% rise in the unemployment rate from the 12-month lows is enough to trigger a recession. In February 2023, the unemployment rate rose by 0.2%, so we may be headed in that direction. It’s worth noting that the job market outperformed expectations in 2022, and it could do so again. Nevertheless, fixed income markets are indicating a recession in 2023, while stock markets do not necessarily share this view.