Is a U.S. Recession Fashionably Late?
Closely watched 10-2 spread is narrowing, a warning sign.
Economists and analysts who have been predicting recession have joined generations of investors who appear to have cried wolf, when there really was no one at the door. After 2022’s market debacle that saw investors endure the first twin declines in stocks and bonds in decades, 2023 was considered by many to be the year the US would go into recession. And the spread between the ten-year and two-year US Treasury securities, which has a nearly flawless streak of forecasting recessions, entered “inversion” territory.
For financial advisors, this is one of those slow-moving trains that can speed up and suddenly become topical enough for clients to start asking about. So it helps to get out in front of it.
That’s the unnatural state whereby longer-term bonds yield less than shorter term bonds. Logically, if one is lending to the US government or any other entity, the longer you are letting them borrow your money, the higher the rate that you’d expect to demand. And that is usually how it goes. Yet inversion first occurred in this market cycle just about two years ago. That should have targeted a recession for some time in 2023. It happened in other parts of the world, but not in the US.
21 is No Blackjack for ETF Investors
Monday, the 10-2 spread reached 0.21% or “21 basis points” inverted. That represents the bond market’s latest lurching attempt toward evening the score, where the ten-year US Treasury finally yields more than the two-year bond. But given the numerous false alarms of the past year or so, ETF investors could be forgiven for not holding their breath and converting their portfolios to be more recession-proof.
There is certainly a history of “lag effects” from interest rate hikes like those we have seen from the Fed (11 of them) since the start of 2022. It takes time for higher rates to slow the economy. And this economy followed a literal “tail risk event” in the form of the pandemic in 2020. So, if the recession to follow was a bit delayed, there may be a good reason.
Is It Different This Time for Economy and Bond ETFs?
Some could point to the massive stimulus in response to those unprecedented circumstances, and the longer time it took for that money to be spent (since we could not go to sporting events and cruises and the like for a sustained period). Or this could be the time the economy simply doesn’t buckle across the board, and that only parts of it falter this time around. So, the full economy is spared a synchronous recession.
Others will point to a deluge of data points that when described usually end with phrases like “in every past case, a recession followed.” The 10-2 spread is one of those.
The long-term average of that indicator is 0.87% (positive), which means that going out about eight extra years netted investors just under 1% of additional income from their bonds.
According to data sourced from the Department of the Treasury, a negative 10-2 spread has predicted every recession from 1955 to 2018 but has occurred six to 24 months before the recession occurring. So, we are about at the tail end of that range. This makes for a most interesting period ahead, since market veterans know that oftentimes, the moment when things “break” is right after the majority opinion has decided they won’t.
ETF investors have many different outlets to try to take advantage of a continued run toward the yield curve reverting to normal. Perhaps the purest play ETF is the $415 million US Treasury 2-Year Note ETF (UTWO) which incidentally has nothing to do with the classic rock band from Ireland. That fund simply owns the most current two-year bond and rolls it over to the newest upon each new US Treasury auction for that maturity. And the 10-year bond is owned the same way by UTWO’s cousin ETF, the $153 million US Treasury 10-Year Bond ETF (UTEN).
Recession talk had faded, and maybe that’s for good reason. But there’s an old expression that ETF investors can keep in their back pocket. Specifically, that the market does all it can to deliver the most frustration to the most investors. With the 10-2 spread starting to quietly creep toward zero once again, it helps to pay attention, rather than wait until it is front page news.