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This recession indicator is predicting one in 18 months

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A recession in America would be bad news for everyone as the ripple effects would be felt globally.

One reliable recession predictor is the US bond market’s yield curve. It’s never been wrong before and it’s predicting a recession is on its way.

The US yield curve flattened significantly in 1990, 2000 and 2007 – all periods preceding recessions.

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And, it’s flattening right now.

Wait – what’s a yield curve?

The yield curve is the difference between interest rates on long-term bonds, versus short-term bonds measured over a certain period.

Generally, long-term bonds, or bonds with longer maturity dates, pay higher rates of interest. This means a normal yield curve has interest rates going up. An inverted yield curve indicates long-term bonds have lower rates of interest than short-term bonds, although this is pretty unusual.

A flat yield curve is usually taken as an indication that traders and investors have concerns about the macroeconomic outlook.

However, it’s not all bad news, according to the head of investment solutions design at Fidelity International, David Buckle.

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“It looks like we’re going into a slowdown. The bond market in the US is saying recession and the bad news is that so far the bond market in the US has never been wrong on this,” Buckle warned at a media event in Sydney.

“Whenever the US bond market has said recession, there’s been one and there’s never been a recession without the US saying it’s going to come.

The equity market tends to do very well in the lead-up to a recession, so I think there will be a time when we’re going to need to be exiting the equity markets but it isn’t now, it’s too soon.”

“The crucial point here is that the equity market tends to do very well in the lead-up to a recession, so I think there will be a time when we’re going to need to be exiting the equity markets but it isn’t now, it’s too soon.”

He said equity markets have between one and two years of good performance before the slowdown hits.

“I’m personally quite relaxed about the volatility we’re seeing in markets right now. This volatility we’re experiencing isn’t the common response to the US thinking there’s going to be a slowdown,” he added.

“Although we’re seeing a lot of volatility in the market, I think that’s due to other factors, I don’t think that’s the market pricing in the likelihood of a slowdown.”

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And, overly cautious investors will pay the price he added, arguing it will be “actually quite expensive” to get out of equities right now.

It usually takes about 18 months for the recession to manifest after the bond market starts projecting.

“The problem of course is it’s such an unusual cycle and that [18 month figure] could be wrong. There’ve been some calling the end of the cycle for the last two years, so you’ve go to be really careful about being too early on exiting.”

What does this mean for us?

A US-led recession will naturally have reverberations in all global markets, Buckle said.

However, the real danger is of a US recession occurring at the same time as China’s growth also slows.

“The relevance for Australia is that China has slowed down, and that’s definite. How hard the slowdown is is the difficult question,” Buckle said.

“The difference between China and America in a long-term macro sense is that America has finished emerging whereas China is still emerging and that means the potential level of growth that China has must continue to drop.”

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It’s difficult to determine how much of a Chinese slowdown will be structural and how much cyclical.

“So, it’s hard to judge how big the slowdown is going to be but certainly it will be a concern to all global markets if we have a slow china and a slow US at the same time.”

An unexpected cushion

Australia’s population growth has historically supported Australian growth, Fidelity Australian Opportunities Fund manager, Kate Howitt said.

She said even if Australia experiences a period of declining GDP per capita, as long as natural population growth and immigration levels stay consistent with the past, the effects will be cushioned.

“That is a support to the economy that most other major developed economies don’t have.

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“[However] it might not be enough to offset if there are headwinds coming from the US and our largest trading partner.”

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