Many investors want to predict the next recession. There’s no imminent sign of a recession, but there is the risk of one in a few years since the economy has been recovering for over 8 years. One of the best signals of a recession is the yield curve. When the Fed raises rates enough, it inverts the yield curve, causing a recession usually a few quarters later. The chart below, shows the history of this process. The blue highlight shows the rate hike cycles and the grey bar shows the recessions.

The time between the last recession and the beginning of the rate hike cycle was long. When you include QE 1,2, and 3 and operation twist, it makes the period look incredibly dovish which is an accurate depiction. It’s interesting to see that this current hike cycle is already near the average length even though it’s probably not close to ending (in terms of timing not amount of hikes). The QE unwind hasn’t even started yet and rate hikes will continue in 2018 although the market is hesitant about there being more than one hike. The other interesting part is that despite the decent hike cycle length, the yield curve hasn’t flattened much. The global QE helped to steepen the yield curve in 2016, showing how QE affects the market. The other reason why the curve hasn’t flattened much is because there hasn’t been that many hikes. The Fed has been very hesitant.

The final part of this chart worth discussing is what it shows the forward curve is pricing in. The yield curve usually flattens during recoveries, especially when the Fed raises rates and the recovery is near its end. The market prices that in to give you an idea when the yield curve will invert. It’s great to look at the yield curve, but this future curve helps you with the specific timetable. Keep in mind, this timetable will change as new economic reports come out. If the economy was on pace to grow less than 1% in Q3, you’d see a sharper decline priced in. As you can see, the yield curve (10-year versus 2-year bond) expects 30 basis points of flattening in 2 years and 70 basis points of flattening in the next 5 years. This would imply the next recession would be in over 5 years.

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