Investing

3 signs professional investors watch to predict possible recessions

Anna-Louise Jackson@aljax7
Twenty/20

Predicting the next recession is difficult, even for the pros. But they try.

The possibility of a downturn is on consumers' minds: Searches of questions like "Are we headed into a recession?" and "Will there be a recession in 2019?" are up more than 4,000% in the past year, according to Google Trends.

Among professional forecasters, 60% believe a recession will start by the end of 2020, according to a June survey from the National Association for Business Economics. That's up from 35% who felt that way in March. Even so, it's worth pointing out that some forecasters have been predicting an imminent recession for years without that happening.

Here are three signs of a possible recession that professional investors keep an eye on:

1. An inverted yield curve

One indicator that professional investors watch closely is the so-called yield curve, which measures the difference in interest rates for two bonds with different maturity dates. You can plot the yield curve for two Treasurys of any duration, but some of the most-tracked are:

  • The 10-year Treasury yield versus the three-month Treasury yield
  • The 10-year Treasury yield versus the two-year Treasury yield

When the economy is expanding, the yield curve slopes upward, because investor optimism about the potential for growth pushes the interest rate on long-term bonds higher than that on short-term bonds. But if investors see the risk of an economic slowdown or recession in the near future, they'll require higher returns to invest in short-term bonds.

VIDEO3:0303:03
How do economic cycles work?

An inverted yield curve means that the yield on longer-term Treasurys is lower than the yield on shorter-term Treasurys. The spread between the 10-year Treasury yield and the three-month Treasury yield has "the strongest predictive power," and an inversion has preceded every U.S. recession in the past 60 years, according to research from the Federal Reserve Bank of San Francisco.

Earlier this year, the 10-year Treasury yield first dipped below that of the three-month Treasury yield—and since May, this yield curve has been inverted. Based on the current spread, the Federal Reserve Bank of New York puts the odds of a recession by June 2020 at about 33%.

But hold off on sounding the alarm bells. The spread between the 10-year and two-year Treasury yields has yet to invert—and the spread between the 10-year versus three-month yield curve appears poised to turn positive again.

2. A rising unemployment rate

The unemployment rate has a perfect track record for predicting recessions, according to Natixis. And when there's a rapid spike in unemployment—particularly a 0.5 percentage point increase in the jobless rate from a prior 12-month low—"the economy is effectively always in a recession," according to research from The Brookings Institution.

In April, the jobless rate fell to 3.6%, the lowest level since 1969. If this remains the low, the above model suggests the U.S. economy will be in a recession once the unemployment rate rate reaches 4.1%.

VIDEO1:5701:57
The difference between a bear market, a recession, and a correction

3. Major declines in the stock market

Of the three recession indicators that pros tend to watch, the stock market is the least reliable. "You'll often see a bear market and a recession happening at the same time—but not always," Caleb Silver, the editor-in-chief of Investopedia.com, recently told Grow. (Check out the video above for his tips to distinguish between the two.)

A bear market is defined as a decline of 20% or more from a recent high for a stock index (like the S&P 500) or any other asset, including an individual stock.

Since 1945, there have been 13 bear markets in the S&P 500, and eight of them overlapped with some part of a recession. That means bear markets have been a recession indicator almost 62% of the time. Based on closing levels, the S&P 500 hasn't experienced a bear market since the 2007-2009 crash that accompanied the Great Recession. And the U.S. economy is in the midst of its longest-ever expansion, which is currently more than 10 years old.

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