The opening acts of recession

By Sean Killin

Since the onset of major central banks’ monetary tightening campaigns in the first half of 2022, the probability of a recession has risen, and much attention has focused on certain risk factors that could portend a possible economic contraction. For example, RBC Wealth Management’s U.S. Recession Scorecard assesses seven leading economic indicators in order to gauge recession risks.

As interest rate hikes start to take their toll, like they are now, it’s also useful to examine three additional U.S. indicators that are typically consistent with conditions that exist at the beginning of or shortly before the onset of a recession. These are known as coincident recession indicators:

• The steepening of the U.S. Treasury yield curve
• Job losses over a three-month period
• Deteriorating consumer confidence

In understanding these indicators, investors can become better equipped to manage risk exposure more tactically in portfolios while navigating the initial stages of recession.

Traversing a steepening slope

When recession risks start to increase, short-term yields rise higher than long-term yields, inverting the shape of the Treasury yield curve. In the current cycle, this started happening in July 2022 and was the yield curve’s first early warning signal of a potential recession.

As the economy subsequently weakens and the bond market responds to changing investor expectations regarding economic conditions, the yield curve tends to re-steepen towards a normal position.

In fact, the re-steepening of the Treasury yield curve into positive territory from an inverted position has historically proven to be the most reliable market indication of imminent recession risk. This typically happens one to two quarters in advance of a recession, but it can occur simultaneously or soon after the onset of one.

In the current cycle, the yield curve has just started to re-steepen, and will fully unwind its inverted state when it reaches above the zero line as depicted in the chart below. When this happens, this would be the yield curve’s second warning signal of a possible recession—an even more imminent warning.

In steep trouble

A steepening yield curve signals imminent recession

The yield curve can steepen by different means. Recently, this process has begun with long-term bond yields rising faster than their short-term counterparts—a phenomenon known as a “bear steepening.” This tends to reflect resilience in the labour market and wider economy, and ultimately supports the case for keeping financial conditions tight or making them more restrictive.

We think this is signalling the bond market believes the U.S. Federal Reserve is likely to maintain higher interest rates for a longer period of time amidst broad resilience in the economy.

If the higher-for-longer rates scenario plays out, this would subsequently further raise net-interest expenses for businesses, ultimately placing additional pressure on corporate profit margins. A margin squeeze and restrictive financial conditions would likely weaken employment prospects and growth expectations, the typical precursors of recession.

The jobs market

Another signal of imminent recession would be when job losses begin to materialize—more specifically, when the three-month average of U.S. non-farm payrolls turns negative.

At present, the U.S. labour market remains robust, thanks to a still-elevated number of job openings underpinned by a healthy pace of job creation. The three-month average is pacing at +266,000 jobs, well above the negative level that would signal trouble.

However, it’s important to consider this indicator has turned negative very quickly in previous cycles, and it could change course just as fast in this one.

Outright job losses signal imminent recession

A vote of (consumer) confidence

A third indicator that can signal the imminent onset of a recession is when consumers’ view of the current state of the economy deteriorates sharply relative to their view of the economy’s prospects six months from now.

This is a survey-based indicator, where perceptions can be influenced by human emotion. Nevertheless, it has been a reliable barometer in gauging the impact of slower growth, weaker labour markets, and tighter credit conditions on the real economy.

This indicator is depicted in the chart below as the view of economic conditions six months from now (expectations) minus the current view of the economy (present conditions). In the current cycle, the indicator has declined to the deep lows that have typically prevailed before the start of previous recessions. A sustained move higher would raise the likelihood a recession was underway.

Greener pastures?

Consumers more confident in future vs. present conditions?

In the clear … for now

None of these three coincident indicators are currently signalling that a U.S. recession is imminent. However, they bear monitoring because if one or some combination of them are triggered soon, that would indicate recession risks have increased notably, and more defensive portfolio positioning would be warranted.

---

---