The outlook for the economy is growing more uncertain. Goldman Sachs recently came out and increased the odds of a recession to 45%.
President Trump and members of the Federal Reserve are pointing fingers at each other for their role in the shaky forecast.
Trump argues interest rates are too high and the Fed should cut. The Fed says it can’t budge on rates because Trump’s tariffs will stoke inflation.
But the reality is that both sides are playing a key role in triggering one recession indicator.
It flashed before 2020’s economic chaos… before the pandemic ever came around.
It happened just before 2008’s financial crisis. And again ahead of 2001’s recession. Both periods saw the S&P 500 lose 50% or more from the top to the bottom.
So while this signal has only happened a few times in the past 40 years, it’s worth paying attention to it. Each time, a recession eventually followed.
Today, let’s look at what that signal is… and what it means going forward…
Follow the Yield Curve
The difference between long- and short-term interest rates is called the “yield curve.”
Usually, the yield curve is in positive territory. That means longer-term rates are higher than short-term rates.
That makes sense because people who buy bonds need more compensation in exchange for locking up their money for a longer period.
But sometimes, the curve inverts. That means short-term rates move above longer-term rates.
That usually happens when the Fed is pushing short-term rates higher. Since higher rates slow the economy, an inverted yield curve warns of trouble ahead.
But when it comes to timing a potential recession, you need to watch when the yield curve uninverts.
Here’s what I had to say about the matter last year:
The yield curve has been inverted since July 2022, but there hasn’t been a recession. That’s because inversion itself isn’t the signal that should concern you.
In the past, it’s when the yield curve uninverts that the recession countdown starts.
There were signs late last year that the curve was starting to uninvert. But that process has accelerated this year.
And both the Fed and the Trump administration are playing a role in triggering this recession indicator.
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Recession Around the Corner?
The yield curve started to uninvert back in September.
Competing forces are driving short- and long-term interest rates even further in different directions.
The tariff-driven inflation outlook is partially responsible for rising long-term bond yields. Ever since the tariff announcements at the start of April, the 10-year Treasury yield has gone from 3.98% to 4.34%.
But short-term rates are falling. The Fed may seem reluctant to cut short-term interest rates further. Yet recall that it has already reduced rates by 1.0% across three meetings last year.
The dual impact of falling short-term yields and rising long-term yields is steepening the yield curve. That’s locking in the recession signal.
Take a look at the chart below. It plots the difference between the 10- and 2-year Treasury yields.
You can see where the yield curve inverted in July 2022 (dropping below the black line). But now the yield curve is firmly back in positive territory above zero… It has uninverted.
Recession periods are the shaded areas on the chart. Going back 40 years, a recession eventually followed a cross back above zero each time.
Of course, there’s no guarantee that we’ll see a recession this time. Yet the indicator can also trigger over a year before a recession is finally felt.
So the clock is ticking… and there’s good reason to be cautious about what lies ahead.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
P.S. The market has been a roller coaster ride this year… Up, down, up, down. That’s made it painful for buy-and-hold investors, who have to watch their capital swing around with each twist and turn.
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That’s why I released a broadcast where I explain my strategy and market forecast on Wednesday morning. But if you didn’t get a chance to watch yet, I wanted to make sure you had a chance.