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Can This Asset Predict a Recession, and Should It Affect Your Portfolio?

Can the Bond Market Predict a Recession?

For the last year or more, many economists and financial analysts have been forecasting a recession, based on bond rates falling into an inverted yield curve. But instead of slowing down, the U.S. economy has shown indications of a recovery, with strong employment figures, decreasing inflation and overall growth. This has some analysts saying the yield curve may not be the reliable recession predictor that it’s often made out to be, while others think it’s too soon to say whether the curve has evaluated the economy correctly in either direction.

Do you need help preparing your portfolio for an economic downturn or other potential risks? Speak with a financial advisor today.

Can an Inverted Yield Curve Still Predict a Recession?

Campbell Harvey, a Canadian economist, was the first to identify the yield curve trend, and he still thinks a recession is on the way. “It’s way too early to say this is a false signal. Way too early,” Harvey told Yahoo Finance.

The yield curve is the gap between short-term and long-term Treasury bonds, calculated as either the difference between the 3-month Treasury bill and the 10-year Treasury bond, or the two-year and 10-year bonds. As of Aug. 24, 2023, the gap between the 3-month bill and the 10-year bond is -1.35%, according to YCharts. On the other hand, the gap with the two-year note on the same date is -0.75%.

An inverted yield curve happens when the discount rates on short-term bonds are higher than long-term bonds, producing a negative gap. In a growing economy, the yield curve is rising because investors typically believe long-term bond rates will go higher as central banks raise rates to avoid inflation if a strong economy grows too fast. When the yield curve reverses, it’s because investors expect an economic downturn will prompt central banks to cut interest rates.

An inverted curve can start as much as 24 months before a recession hits. So far, the 10-year/2-year curve has been inverted for 13 months, while the 10-year/3-month curve has sloped downward for 10 months, according to data from LongTermTrends. Meanwhile, U.S. stocks have turned in positive results, with the S&P 500 index up nearly 14% for 2023.

“The longer we go after the inversion, people start to doubt the indicator, which is fine.” Harvey said. “I characterize it as a lull before the storm.”

But this post-COVID economy is different, some analysts say. For these people, the inverted curve has more to do with two-plus years of near-zero interest rates that didn’t end until May 2022, and demand for the safety that longer-term Treasuries will offer if the Federal Reserve starts cutting rates in 2024.

“Overall, the yield curve has become less of a recession indicator over the last two economic cycles,” said Morgan Stanley U.S. Chief Economist Ellen Zentner. “And when we look at factors in the economy that are typically signals of a recession, such as job growth, retail sales, real disposable income and industrial production, we don’t see an approaching recession.”

How Should Investors React With Their Portfolios?

Can the Bond Market Predict a Recession?

Should investors pile money into short-term bonds and avoid stocks before a recession sends share prices plunging? Or should they listen to the positive economic signs and stick with stocks that could continue to head higher? 

For retirement investors, the most common answer is to invest in a diversified portfolio of stocks, bonds and cash that can provide the income needed to support a 30-year retirement. However, remember that everything that goes up in the financial market eventually does come down.

This retirement calculation depends on whether you have a pension, your expected Social Security benefits, your savings and other assets, as well as your own individual risk tolerance. Ideally, a retirement portfolio is built to take the least risk necessary to provide a steady retirement income, even when a recession hits. You may also want to monitor and adjust your portfolio strategies to keep up with your long-term goals.

Bottom Line

The U.S. economy may or may not be headed for a recession, but smart investors know downturns are inevitable and build their portfolios to minimize risks. Investors have traditionally relied on an inverted yield curve to predict lower growth, rate cuts and the tightening of credit conditions during a recession. But this can also be an unreliable indicator as experts also point out that it can’t forecast the timing or severity.

Tips for Investing in a Recession

  • A financial advisor can help you prepare for economic downturns in the market. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • If you’re looking for help with your investments during a recession, here are five practical tips to follow.

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