- A briefly inverted yield curve has had predictive power in past recessions.
- Stagflation concerns are rising as the U.S. Federal Reserve attempts to balance inflation, interest rates, and unemployment.
- Consumer sentiment hits historic lows in the last decade.
For every rosy report prognosticating an improving economy and prospects, there seems to be a multitude of counterpoints suggesting a real chance of recession. The recession, if it transpires, could lead to a prolonged period of downturn in which almost everything in daily life becomes more difficult.
And as unfortunate as it is, the truth is that there are real signs flashing before our eyes. No one reading this wants a recession. I certainly don’t either. Despite what we want though, a prolonged downturn could be ahead. We have to divorce ourselves from hope and look at the real possibility.
That requires us to identify and understand the warning signs. Headlines are filled with the three signs discussed here. Treasury yield curves have indeed inverted recently. That has been a very bad signal in the past. Below, we discuss what to look for moving forward.
Current woes are leading to the very real prospect of stagflation, something the U.S. hasn’t dealt with since the 1970s. All of these fears are causing psychological effects, as well. Sentiment is flagging. That also bodes poorly for the simple fact that negative belief can lead to negative outcomes.
Let’s unpack those three signals and see why there is a good chance things could be getting worse moving forward.
Recession Warning Signs: Yield Curve
On Mar. 29, the Treasury market flashed a very scary signal for keen followers of the economy. The 10-year Treasury yield fell below the 2-year Treasury yield for a few moments.
What that means in technical terms is that short-term debt instruments yield a greater return than long-term instruments of similar credit risk. It is also a notable proxy for an impending recession. It is a rare occurrence when yield curves invert, but there is nuance here worth understanding.
The bad news is that inverted yield curves have preceded every recession since 1955 with one exception in 1960.
The good news is that this latest occurrence wasn’t prolonged enough to draw much from conclusively. Studies have shown that inverted yield curves have remained inverted for at least a week when those recessions resulted. That indicates that fears could be overblown.
So, what happens if those yield curves invert again and stay inverted for a week or more? The answer there is also nuanced. But if history is an accurate indicator, a weeklong inversion should signal a recession that will last anywhere from six months to two years.
Stagflation Concerns
Stagflation is one of the more prominent buzzwords circulating in relation to our current economy. It is characterized by a combination of high inflation, slowing economic growth, and steadily high unemployment.
The reason some economists are worried relates to the balancing act between inflation and unemployment. One problem is that most economic tools to combat inflation result in increasing unemployment. Unemployment sits at a relatively modest 3.6% currently, down from historically high levels during the pandemic.
But the U.S. Federal Reserve (Fed) hiked interest rates on Mar. 16 by 0.25%. When this happens, the rate at which businesses can borrow money also increases. That makes it more difficult for businesses to hire employees. In turn, unemployment levels can increase. Those rate hikes are going to continue in 2022. And with the possibility of 0.5% hikes not out of the question, unemployment could spike.
On the other hand, if you decrease unemployment, inflation can rise. That is exactly what the Fed is already battling and it puts the economy into something of a Catch-22 situation in which there are no easy solutions.
Recession Warning Signs: Consumer Sentiment
Consumer sentiment continues its downward journey as we head into April. The University of Michigan Consumer Sentiment Index (MCSI) continues to slide by all measurable comparisons. The index ended March at 59.4%. That figure represented a 5.4% decline from February’s ending reading and a 30% decline from the final reading in March of 2021.
As many readers may have suspected, the primary reason for the flagging sentiment figures is inflation. Current estimates are that the year ahead will be marked by an inflation rate of 5.4%.
That might seem like positive news given February’s 7.9% inflation rate, which was the worst in the past four decades. However, that same article notes that such an inflation rate for the coming year would be a similar four-decade low.
The consumer sentiment figures have also been negatively affected by Russia’s ongoing war in Ukraine and concerns about Covid-19. In essence, households are more negative about their financial prospects moving forward. The risk here is that the psychological effects of negative sentiment add to consumer behavior in ways that cause the economy to worsen and head further toward recession and a prolonged downturn.
On the date of publication, Alex Sirois did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
