Are we entering a recession soon? My takeaway from yield curve spreads
Hey guys, time for me to update my articles on Medium. Today I want to show you guys my super simple analysis on whether we are heading into recession soon.
Just a while ago I saw this tweet by someone, which really intrigued me:
If we look closer at the chart:
As you can see, whenever it went above 18 in the past, a recession always 100% occured. HOWEVER, the problem is that this only occured twice in the past. The sample size is simply too small.
Now, we switch to better nindicator: the yield curve spread or yield curve inversion.
Financial media and institutions normally love looking at the spread between 2 year bond yield and the 10 year bond yield to determine if we will head into recession soon. When the spread is above 0 (aka yield curve showing signs of inversion), it usually signals recession will happen within 1 or 2 years.
I backtested this with different yield maturity periods and what I find is that the difference between fed fund rate and 10 year bon yield actually gives higher accuracy and much better predicting power. Or you can use 3 month bod yield as close substitute. 3 month bond yield and fed fund rates co-move almost together.
Below shows the historical results I put on a spreadhseet:
As you can see from the table above, whenever fed fund rate crosses above 10Y yield, a recession always happens within 10.63 months on average.
So… has the yield curve inverted yet? No. You can check this easily on tradingview:
I don’t think we are heading into recession yet because yield curve hasn’t inverted yet at all. This yield curve spread is a leading indicator that has been working 100% from the 1960s till now. As long as the global financial system doesn’t change drastically, I believe it will keep working. Some even joked that the inverted yield curve caused the pandemic! (Yield curve inverted around March 2019 and the pandemic induced market sell-off started in February 2020!) Of course that was a joke. Even if covid didn’t happen, I believe something else would have happened to trigger the recession in 2020
Therefore I conclude that we haven’t seen any signs of getting into recession. I will start worrying till yield curve inversion happens. That’s why I still hold the believe that it’s simply a correction for S&P 500 and other market indices in the near term (even though it is indeed bear market for growth stocks)