Does 10-2 Treasury Spread Finally Signal Recession?

ETF price trends may offer clues as to whether or not the long-awaited recession is actually coming.

The 10-year US Treasury bond now yields more than the 2-year Treasury note for the first time since May, 2022. 

While that might seek normal to newer investors, it's in fact the opposite of normal. 

Unless a recession is coming.  

As the chart shows, recessions tend to start shortly after that “10-2 spread” regains positive territory following a period of “inversion.” That’s what happened late last week. And while the pandemic has absolutely thrown a big fat wrench into many aspects of investment market analysis, this reversion indicator has a spotless record.

For every recession hawk, there seems to be someone in the investment business who thinks the opposite. But for investors in ETFs, the thing that really matters isn't what happens in the real world. No, it's what happens to the value of their portfolio.  

Let's say for a moment that recession is coming our way. In a different article this week, I focused on technical analysis, confined to the 10-year US Treasury bond. Now let’s look beyond that narrow market area, and see which ETFs are starting to point toward being either profit centers or at least decent places to hide if that recession hits.

Beyond Bonds

Lower rates are positive for bond investors. The exception may be those who have enjoyed very high yields on T-bills, which have yielded even more than two-year bonds for a while now. That was perhaps the most bizarre part of these past two years for investors, though I don’t think T-bill investors are complaining!

Within the stock market, history is somewhat of a guide. Sectors like consumer staples and healthcare have a “defensive” reputation. So too do higher-yielding sectors like utilities and real estate (REITs), which potentially benefit from lower rates that accompany recession.  

That latter point is something that has an interesting historical context. Today’s advisor and self-directed investor has an unconstrained investment mandate. The advisor gets to understand the client’s risk tolerance and time horizon and customizes a portfolio to that end. The world is open, especially with more than 3,000 ETFs to choose from.

Don't Stay in Your Lane  

But back when so much investment work was confined to big institutions, many managers were forced to “stay in their lane.” And if their lane was to be fully and always invested in U.S. stocks, they had to grapple with periods where the whole stock market looked barren, though interest rates were falling, so bond prices were up.  

That often led them to utility stocks, since those companies were the closest thing to bonds. They were highly regulated, offered higher yields and didn’t grow revenue and earnings much.  

But now utilities are a different type of stock, and markets tend to treat them a bit more like stocks than before. How else do we explain the unusually large price gyrations in ETFs like the SPDRs Select Sector Utilities ETF (XLU) in recent months? Suddenly, utilities were considered by some to be Artificial Intelligence plays. So much for the old days!

There is a case to be made for financial stocks, particularly banks, and funds like the SPDR S&P Bank ETF (KBE) represent that industry. However, while a “normal shaped” yield curve is on par good for banks, since their lending rates exceed the rates they pay on deposits, recessions tend to dampen economic activity.

Investor Education is the Priority

There’s no right answer here, since every investor is different. And in my experience, there are two types of weak stock markets. Some have places to hide, and some don’t. And often, when recession fears creep in, the first of those occurs, then the second kicks in.

This is where it can be helpful to learn more about defensive investing, including how to apply the many inverse ETFs available. That roster includes several which have been battle tested for a couple of decades and do not use leverage. The takeaway here: better to get educated before the markets start to panic.