Recession Primer, Part Four: Recession Signals

This is part four of a series on recessions, specifically recession signals. Click here for part one. Click here for part two on what recessions look like. Click here for part three on why recessions occur.

Throughout the business cycle, there are signals that suggest changes could be just around the corner. When economists or investors want to know if a recession is likely, they look at indicators like the yield curve to see if there is a risk. Of course, no recession indicator is perfect, but if a significant number of them are flashing red, then a recession may indeed be on the horizon. 

Inverted yield curves

Perhaps the most-watched signal that could suggest a recession is about to occur is an inverted yield curve. When the yield on the 10-year Treasury falls below that of the two-year Treasury, it means the yield curve has inverted. 

Healthy markets have a yield curve that’s lower on the left and moving gradually higher toward the right. This indicates that bonds with shorter maturities have lower interest rates than those with longer maturities. From a logical standpoint, this just makes sense because there is more risk inherent in longer maturities. In the case of government bonds, investors’ capital is tied up for a longer period of time before the final payoff. 

When the yield curve inverts, it means the yield on shorter-term bonds is higher than the yield on longer-term bonds. Although an inverted yield curve doesn’t mean a recession is imminent, it is a sign that one might not be far off. Credit Suisse estimates that on average, recessions occur approximately 22 months following an inversion of the yield curve. 

Corporate earnings and profits

Market watchers also look at projections for corporate earnings and profits. When the economy is healthy, corporate earnings and profits are increasing steadily as consumers spend money. However, earnings estimates which show projected declines suggest consumers aren’t spending as much money as they did before. 

Investors and analysts often use estimates from FactSet to determine whether earnings are on the rise or are declining. Frequently, earnings from companies in the S&P 500 are added together and checked against numbers from the recent past. Individual companies often issue guidance along with their earnings reports, telling investors whether to expect earnings growth or decline. If earnings growth is decelerating, it represents an early sign that an earnings decline may not be far off.

Estimates don’t always turn out to be correct, but the simple fact that analysts and the companies themselves are projecting declines indicates a perception of weakness in the economy. If weak estimates start to play out in the market, it indicates that the economy is definitely slowing down, which is an indicator of recession.

GDP

Economists also look at the nation’s gross domestic product to see if the economy is slowing or in decline. The GDP measures the market value of all the goods and services produced by the nation during a particular timeframe. When fewer goods and services are produced, it means the economy is contracting. A temporary decline in GDP isn’t always a cause for concern, but if the economy contracts for at least two consecutive quarters or six months, it officially means a recession is underway.

Economists also look at the output gap, which is the gap between the economy’s actual output and the level economists project to be its maximum potential. Another measurement of GDP that’s taken into consideration is the real GDP, which is adjusted for inflation. Any slowdown in growth is the first sign that a change may be underway, but it isn’t until the GDP is actually falling that it indicates a recession may be occurring or about to occur.

Sentiment 

Another warning sign of a potential recession is consumer and business sentiment. While this indicator is entirely psychological in nature, it does show what the prevailing feeling is about the economy. Business owners who feel good about the economy are more likely to expand their business or hire more workers. They’re going to keep producing the same or a larger number of goods or services because they expect consumers to continue buying what they’re offering. A number of different gauges from organizations like the Conference Board and the National Federation of Independent Businesses offer insight into how business owners are feeling about the economy.

The Consumer Confidence Index measures consumers’ feelings about the economy. When consumers are worried, they don’t spend as much money as they do when they aren’t concerned. They tend to save because they believe difficult times are coming, so they’re putting money away for the future in case they lose their jobs. 

Investors also show how confident they are in how they invest. They have a greater appetite for riskier assets when times are good, but they rotate out of riskier assets like stocks and into safe-haven investments like gold or bonds when there are potential signs of trouble. Knowing which recession signals to look for helps them determine how they invest.

Employment numbers

The jobs report and other employment-related data also offer important indicators of whether a recession is near or already underway. Let’s look at employment-related data as recession signals. Unemployment is the most obvious indicator because if more and more consumers are out of work, it means they have less money to spend. When consumers can’t afford to spend money, the economy contracts, as reflected in the GDP. 

Other employment-related data also provides insight into how the economy is doing. The Department of Labor also reports the number of jobs created in each sector, the number of hours worked and seasonal work. Business owners who are worried about the economy might reduce the hours their employees work. On the other hand, business owners who hire seasonal help are expecting the economy to remain strong in the near future. Job creation is also a sign of a healthy economy. 

Other recession signals or indicators

Aside from hard data and sentiment, there are some other recession signals or indicators which could suggest whether or not a recession is occurring or about to occur. For example, the Federal Reserve Bank of New York publishes a recession probability gauge. The district central bank bases its probability indicator on the spread between the yields of three-month and 10-year Treasuries. The New York Fed also looks at other data to estimate the probability of a recession occurring within the next year.

Two other recession signals are the U.S. Conference Board’s Present Situation Index and Leading Economic Index. The former is a sub-index that looks at consumer sentiment, and the Consumer Confidence Index is based on it. To calculate this index, the Conference Board conducts a survey. The Leading Economic Index is designed to forecast economic activity in the near future. The index reveals troughs and peaks in the business cycle, and historically, it has declined before recessions and risen before economic expansions.

Another recession signal some economists watch is the Chicago Fed National Activity Index, which takes into account production and income, employment, unemployment, and hours, personal consumption and housing, and sales, orders, and inventories. The CFNAI Diffusion Index is a three-month moving average based on each of the values of the main index.  

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

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