Predict the Next Recession

If you know what to look for and how to cut through the noise of the financial media to identify historic signals of an oncoming recession, businesses and consumers can take the additional steps to financially plan and prepare for a recession, much in the same way a homeowner might for a coming hurricane. Taking steps such as building an emergency fund to cover at least 3 months of expenses or adding additional funds to an existing one, paying down existing high interest debt, avoiding new long-term debt obligations, and examining the family or business budget for areas to reduce spending such as that subscription service that no one seems to actually use but costs the business or family $200 a year. 

Since 1955, by the San Francisco Federal Reserve's count, an inverted yield curve has accurately forecast all recessions, 9 of them to be exact, during that time. The average time from the yield curve inversion to the start of the recession, as identified by the National Bureau of Economic Research (the umpire of US business cycles) is 18 months. Given the current economic expansion is set to become the longest in the history of the United States by mid-2019, the only certainty is that a recession will occur. The debate is when.

According to Investopedia’s definition, an inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.

In simpler terms, an inverted yield curve is when a longer-term debt instrument, like a 10-year treasury note, has a lower yield than a short-term debt instrument (2-year treasury notes) of the same credit quality, indicating the market concern with the longer-term prospects of the macro economy. An inverted yield curve has preceded the last nine US recessions, including the last two beginning in 2001 and 2007. The inversion of the yield curve preceded the Great Recessions, which started in December 2007, by 16 months. For individuals, households, and businesses, that is ample time to prepare.  

The yield curve inverted or fell below 0 in 2006.  The Great Recession started in December of 2007.  

The yield curve is exhibiting a flattening profile at best or a continued downward trend at worst, and the longer-term trend, as a correlation for economic output is not looking favorable. It is important to note the debate occurring about whether the inverted yield curve will be able to predict the next recession. The cited reason is the Federal Reserve’s asset purchase program, known as Quantitative Easing (QE), put in place during the Great Recession to lower interest rates and increase the money supply to stimulate demand. The theory goes that this intervention in markets will interrupt the inverted yield curve process and render it useless as a prediction tool. In fact, the yield curve is actually flattening in a pattern not dissimilar from yield curves leading to an inversion. This is causing concern (and forecasts) of an inverted yield curve in mid-2019. 

It’s also important to remember that using 'the runway' an inverted yield curve provides in terms of preparing for a recession could be argued as a self-fulfilling prophecy. Consumers, for example, start to pull back on spending in anticipation of the recession, and, with consumer spending account for nearly 70% of Gross Domestic Product, the pullback results in less demand, less economic activity, and a recession is born. When the yield curve inverts, central bankers, politicians, and pundits usually attempt to ease concerns about a coming recession with messages that all is well and this time is different in the media. Use publicly-available data to draw your own conclusions.

The second marker of an oncoming recession is, interestingly, copper prices. Copper is a great proxy of economic activity because it is used across many different industries such as home construction, manufacturing, consumer products, and commercial products. 

On July 19th, copper prices hit a one-year low. “Doctor Copper” as it is referred to by economists and financial experts is often seen as a leading indicator of future economic trends. From Investopedia, The term Doctor Copper is market lingo for the base metal that is reputed to have a Ph.D. in economics because of its ability to predict turning points in the global economy. Because of copper's widespread applications in most sectors of the economy — from homes and factories to electronics and power generation and transmission — demand for copper is often viewed as a reliable leading indicator of economic health. This demand is reflected in the market price of copper. Generally, rising copper prices suggest strong copper demand and, hence, a growing global economy, while declining copper prices may indicate sluggish demand and an imminent economic slowdown.

It is also important to note that copper prices are highly influenced by trade control mechanisms such as tariffs, and in 2018, the US introduced 25% tariffs on steel and aluminum, which can indirectly influence the price of copper and lessen Dr. Copper’s ability to predict future economic performance. (On a side note, tariff policy has always ended poorly. For example, the Smoot-Hawley Tarrif Act of 1930 and the Federal Reserve’s interest rate increases at the time, are universally panned as turning a deep recession into The Great Depression. 

Source: Nasdaq.com.  Copper 2 year pricing.  

Source: Nasdaq.com.  Copper prices since July 2008.

The Capitalist economic system is the best available to society today, but like freedom, as John F. Kennedy said in his 1963 address to Berlin, it is not perfect. During every recession there are individuals, households, and businesses that are left standing in the recession-driven game of musical chairs. These left standing pay a high price during a recession. In looking for the signals and planning accordingly, steps can be taken in advance to successfully weather the recession storm. Are you prepared?