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Proceed with caution

Just as night follows day and June follows May, recessions follow expansions. The length and timing of recessions are not as predictable as the length of our days or the time of the year, but sooner or later, a recession is coming. It’s inevitable. Rather than a question of whether a recession is coming, the question is, when will the next recession hit, and how long will it last?

Try as they might, economists have yet to develop infallible tools to definitively predict when recessions hit. Still, one reliable predictor of future recessions is the yield curve, which is simply the difference between short-term and long-term interest rates.

Inevitability of recessions

Our economic policymakers have been able to tame the business cycle, although they have been unable to eliminate recessions. Odds are they never will. The business cycle consists of four phases including: (1) expansion, (2) peak, (3) contraction/recession and (4) trough. An organization of renowned economists, the National Bureau of Economic Research, decides the official starting and ending dates of recessions and expansions. Those starting and ending points coincide with economic peaks and troughs. Decades ago, NBER economists performed pioneering studies of the business cycle, so they have had the official word on when recessions begin and end.

Given their name, you might think the NBER is a government agency. Not so. Instead, “the NBER is a private, non-profit, non-partisan organization” of leading economists including numerous Nobel Prize winners in economics as well as several past chairs of the president’s Council of Economic Advisers. According to the NBER, from 1854 to 2009, the U.S. economy has experienced 33 business cycles. To the credit of our economic policymakers, the average length of recessions has been decreasing while the average length of expansions has been increasing (see table). Nevertheless, there is little, if any, hope among economists that recessions will ever be completely avoided.

Yield curve warning of possible recession

Wonky phrases like “yield curve” and “term spread” are enough to make anyone’s eyes glaze over, but they are not overly complicated. A yield curve simply shows the difference between the interest rate paid on long-term bonds and short-term bonds; it shows the “term spread” between long-term bonds and short-term bonds. According to the article “Economic Forecasts with the Yield Curve” by Federal Reserve Bank of San Francisco economists Michael D. Bauer and Thomas M. Mertens, “The term spread is one of the most reliable predictors of future economic activity among a wide range of economic and financial indicators and, as such, is closely watched by professional forecasters and policymakers alike.” In good economic times, interest rates on long-term bonds are usually higher than rates on short-term bonds, so the rates on long-term bonds minus the rates on short-term bonds is greater than zero; the term spread is positive. In contrast, the term spread is negative when interest rates on long-term bonds are lower than rates on short-term bonds, and that is a warning sign that an economic slowdown is on the way. Again, according to Bauer and Mertens, “A simple rule of thumb that predicts a recession within two years when the term spread is negative has correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession. The delay between the term spread turning negative and the beginning of a recession has ranged between 6 and 24 months.”

Several times on Thursday (Aug. 22) and Friday (Aug. 23), the yield curve/spread between 10-year U.S. Treasury bonds and two-year bonds was inverted (negative). Consequently, there is heightened concern that a recession might now be on the horizon.

What you can do now

In their report “How to recession-proof your life,” CNBC reporters Sharon Epperson and Michelle Fox list four tips to help you prepare for a recession including:

1. Focus on what you can control.

2. Shore up your finances.

3. Get cautious about your spending.

4. Protect your portfolio.

Ironically, their advice to shore up your finances and get cautious about your spending are two behaviors that reduce consumer spending and increase the likelihood of a recession.

Like a yield sign on the highway that warns us to drive with caution, the yield curve/spread is now warning us to proceed with caution in our economic affairs.

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