Here’s a More Reliable “Recession Indicator” Versus an Inverted Yield Curve

“The lead time between past inverted curves and economic contractions is widely variable”

By Elliott Wave International

Longer-dated bonds generally yield more than shorter-dated bonds to compensate an investor for assuming the greater risk of tying up money for a longer time.

As examples, 30-year government bonds have historically offered investors a higher yield than 10-year notes, and 10-year notes generally provide a higher yield than 2-year notes.

However, there are times when the yield on a shorter-term bond is higher than a longer-term bond. This is known as an inverted yield curve, and many market observers view this occurrence as a signal that a recession may be just around the corner.

For example, a March 28 CNBC headline said:

5-year and 30-year Treasury yields invert for the first time since 2006, fueling recession fears

The next day, on March 29 and then again on April 1, the yield on 2-year U.S. treasury notes climbed above the yield on 10-year U.S. treasury notes — prompting more potential recession talk. A key reason why is that a yield inversion has preceded every U.S. recession since at least 1955.

However, here are some important insights from our just-published April Elliott Wave Financial Forecast, a monthly publication which provides analysis of major U.S. financial markets:

The lead time between past inverted curves and economic contractions is widely variable … and usually does not occur until after the curve un-inverts. Since stock prices lead the economy, it is more reliable to monitor equities to estimate when the onset of an economic contraction may occur.

Indeed, here’s some historical evidence of that from Robert Prechter’s landmark book, The Socionomic Theory of Finance, which says:

It is important to understand that socionomic causality does not predict that each stock market decline will produce an official recession as defined by the National Bureau of Economic Research; it predicts that stock market declines and advances will reliably lead rather than follow whatever official recessions and recoveries do occur.

So, keep an eye on the stock market’s Elliott wave pattern for a clue about what’s ahead for the economy.

If you’re new to Elliott wave analysis, or simply need a refresher on the topic, you are encouraged to read Frost & Prechter’s Wall Street classic, Elliott Wave Principle: Key to Market Behavior.

Here’s a quote from the book:

In the 1930s, Ralph Nelson Elliott discovered that stock market prices trend and reverse in recognizable patterns. The patterns he discerned are repetitive in form but not necessarily in time or amplitude. Elliott isolated five such patterns, or “waves,” that recur in market price data. He named, defined and illustrated these patterns and their variations. He then described how they link together to form larger versions of themselves, how they in turn link to form the same patterns of the next larger size, and so on, producing a structured progression. He called this phenomenon The Wave Principle.

You may be interested in knowing that you can read the entire online version of Elliott Wave Principle: Key to Market Behavior for free.

You can get that free access by joining Club EWI, the world’s largest Elliott wave educational community.

Club EWI membership is free and allows you complimentary access to a wealth of Elliott wave educational resources on investing and trading without any obligation.

Just follow the link to get started: Elliott Wave Principle: Key to Market Behavior — free and unlimited access.