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The Most Reliable Recession Indicator in History Just Triggered

There are many signals investment professionals use to gauge the health of the economy and more importantly, to determine when a recession is about to occur. Since asset prices, including stock prices, plummet during recessions, investors and professionals who can avoid losing money during a Bear market find themselves with a rare opportunity to buy risk assets at a low price. The most reliable indicator is the yield curve, which is expressed by taking a long-term Treasury yield and subtracting a short-term Treasury yield to determine the spread between the two.

The reason the difference between short-term and long-term Treasury yields is an important gauge of the health of our economy is that bank lending profits are based on this gap. Banks borrow at short-term rates and lend at long-term rates, so the difference between the two is critical to the health of the banking system. The larger the gap, the greater bank profits are and the narrower the gap, the lower bank profits are.

In a debt-based economy, such as ours, where there is more debt than currency to pay off the debt, the amount of debt in the economy needs to continuously expand to avoid a deceleration or an outright collapse in the currency supply. When the yield curve “flattens” or outright inverts, it means banks will drastically cut back or even cease lending operations.

The most accurate yield curve is the difference between 10-year Treasury yields and 3-month Treasury yields. Going back to the early 1970s, when this data series first began, it has accurately predicted every recession. Only one time, when the hedge fund Long-Term Capital Management blew up in 1998, did an inversion of the 3-month, 10-year yield curve not trigger a recession. Two years later, the inversion of this curve would signal the bursting of the dot-com bubble.

Even Larry Kudlow, an American financial analyst and former television host who is currently serving as the Director of the National Economic Council under the Trump Administration, stated in a 2018 CNBC interview that every recession has been led by an inversion of the 10-year and 3-month Treasury yields. Back in July 2018 when Kudlow was interviewed by Jim Cramer on CNBC, Kudlow made it clear there was no recession in sight. Today, the 10-year, 3-month yield curve is telling us a recession is imminent.

As of the close of business on Wednesday, March 27, the spread between the 10-year Treasury yield and 3-month Treasury yield was -0.05%. Many will be quick to point out that inversion does not immediately lead to a recession, which is correct. Historically it can take six months or more before inversion of the 10-year and 3-month Treasury yields causes the economy to recess.

Based on historical data, it suggests the good times are still here. But when the M2 Money Supply is charted alongside the 10y3m yield curve, it explains why prior inversions did not trigger an immediate recession. In each case, the annualized growth rate of the money supply was high and it took six months or more for the growth rate of the money supply to slow enough to trigger a recession.

Today, the annualized growth rate of the money supply is low, and already near a dangerously low growth rate associated with past recessions and depressions. Any decline in bank lending with only cause the growth rate of the money supply to slow at an even faster rate as banks curtail lending. With interest rates near zero, the solution is about to exasperate the problem.

The challenge with low or zero interest rates it that as principal payments are made against a loan, money is destroyed. When banks reduce lending, an insufficient amount of money is being created to offset the destruction of money. Banks are aware of this problem, which is why the largest commercial banks are buying U.S. Treasury bonds to protect themselves against the next recession.

Stocks prices do not like inverted yield curves, especially bank stocks. Stock prices prefer rising long-term yields with low or slowly rising short-term yields. The prior two recessions began as the 10y3m yield curve inverted. The “Smart Money” understands how an inverted yield curve affects asset prices, so going into an inversion, the “Smart Money” unloads their stocks on to the unsuspecting public.

When examining the price charts of the past two recessions, the dot-com top was around nine months in duration, as was the top of the mortgage bubble. The current market top is fifteen months in duration, making it the longest topping pattern in history. The length of a topping pattern is significant, as it shows how much time the “Smart Money” needs to offload its shares, plus the length of the top is often associated with the size of the move down in stock prices.

Long-term bonds, on the other hand, relish inverted yield curves. Bond prices soar as disinflation takes hold of the economy and as investors flee their risky stocks for the safety of bonds. Bond prices often rally for a year or more after the inversion.

As far as the “Smart Money” goes, they have been buying U.S. Treasury bonds in droves. The topping pattern in 10-year Treasuries is around twelve months, making it one of the longest topping patterns in the history of the Treasury market. The “Smart Money” is expecting long-term bond yields to plummet, where they will sell their bonds to retail investors who tend to sell stocks near the bottom of a market in exchange for bonds, which are usually topping around the same time.

The annualized rate of change in gold prices also follows the 10y3m yield curve. When the curve is falling, as it has been for the past six years, gold prices tend to flatten or decline – and they did. Gold anticipates and responds to a rising 10y3m yield curve, which can occur in one of two ways.

A rising yield curve happens when short-term yields fall faster than long-term yields, which can happen when the Federal Reserve lowers the Federal Funds rate. I wouldn’t be surprised if the Fed lowers the Federal Funds rate later this year, nor would I be surprised if it went back to zero percent. After all, the global economy is reeling from the Fed’s monetary tightening regime.

A rising yield curve can also happen when long-term yields rise faster than short-term yields, which would happen during inflationary periods where the Fed is injecting liquidity into the economy while at the same time, suppressing short-term yields. The last time the Fed did that was during the early stages of Quantitative Easing, where the 10y3m yield curve steepened, along with gold prices. This too could happen, but not until after the Fed has lowered the Federal Funds rate to zero percent.

Crude oil prices are not immune to a rising or falling yield curve either, as oil prices have a strong relationship to the direction of the yield curve. Since the yield curve is falling and likely to continue falling until the Fed lowers short-term interest rates, crude oil prices should also fall.

What is interesting about the 10y3m yield curve is what leads it to rise and fall in a similar fashion with each business cycle. In the late stages of the business cycle, after the Fed has significantly eased, investors believe currency-printing inflation is coming, so they sell and short U.S. Treasury bonds. By selling and shorting U.S. Treasury bonds, long-term yields rise faster than short-term yields.

Short-term yields rise as the Fed raises the Federal Funds rate, but the Fed is notoriously slow with raising rates. When long-term rates rise faster than short-term rates, the yield curve rises. As the Fed’s tightening cycle matures, large commercial banks begin buying U.S. Treasury bonds as economic growth slows.

When the banks start buying long-term U.S. Treasury bonds to hedge against loan delinquencies and defaults, the yield curve starts to fall, since the Fed is usually still raising short-term interest rates at this point. Once the Fed realizes they have gone too far, the spread between long- and short-term yields becomes very small, just like it is today.

The banks continue to buy U.S. Treasury bonds at this point, which starts to squeeze the speculators out of their short-Treasury bond positions. As the short squeeze builds, long-term rates fall below short-term rates. When the yield curve is inverted, when long-term rates being below short-term rates, lending dries up.

The Fed, in order to keep banks lending, is then forced to lower the Federal Funds rate. With ten-year Treasury yields likely to revisit their all-time lows in the near future, and perhaps set new all-time lows, the Fed will be forced to lower the Federal Funds rate back to zero and restart their Quantitative Easing program.

Knowing how the Fed is trapped in this cycle, which is being dictated by the largest banks and investors who sold or shorted the U.S. Treasury bond market, it gives forward-looking investors a preview of what is to come. It is reasonable to assume the 10y3m yield curve will invert and continue inverting until the Fed lowers the Federal Funds rate.

From an investment standpoint, stock prices are headed significantly lower. Long-term U.S. Treasury bond yields are also headed lower, which will cause U.S. Treasury bond prices to rise.

Gold may drop in the short term, but it performs well when the Fed is forced to capitulate and lower interest rates to drive the yield curve up. For good reason, the “Smart Money” has been buying up all the gold they can over the past six years. For the Fed to drive the yield curve higher, they will have to implement a Quantitative Easing program much larger than Quantitative Easing 1-3.

The real story is where stock prices are headed during the next downturn, which is normally difficult to predict. However, stock prices are correlated with the Monetary Base or the total currency in circulation plus bank excess reserves, so it is possible to extrapolate where stock prices are likely headed. Should the S&P 500 reconnect with the Monetary Base, it would need to fall to about 1,650 points from about 2,800 where it is today, or about -41%. For the Dow Jones Industrial Average, it would need to fall to around 16,000 from its current value of about 25,500, or about -37%

The impending inversion of the 10-year and 3-month Treasuries is just another indicator among many others that are signaling an impending recession along with a major downward move in stock prices. Since the 10y3m yield curve has accurately predicted every recession in the past, investors would be wise to follow the “Smart Money.” The “Smart Money” has been moving out of equities and into bonds and they have also been buying gold in anticipation the Fed will be forced to reinstate a zero-interest rate policy. As more recessionary signals trip, it is only a matter of time before the floor falls out of the stock market.

has been buying up all the gold they can over the past six years. For the Fed to drive the yield curve higher, they will have to implement a Quantitative Easing program much larger than Quantitative Easing 1-3.

Crude oil will head lower before it rockets higher as the yield curve steepens. Here again, the “Smart Money” is well aware of the relationship between crude oil prices and the yield curve, which is why corporate oil executives and other large investors have been dumping their oil company stocks.

The real story is where stock prices are headed during the next downturn, which is normally difficult to predict. However, stock prices are correlated with the Monetary Base or the total currency in circulation plus bank excess reserves, so it is possible to extrapolate where stock prices are likely headed. Should the S&P 500 reconnect with the Monetary Base, it would need to fall to about 1,650 points from about 2,800 where it is today, or about -41%. For the Dow Jones Industrial Average, it would need to fall to around 16,000 from its current value of about 25,500, or about -37%.

The impending inversion of the 10-year and 3-month Treasuries is just another indicator among many others that are signaling an impending recession along with a major downward move in stock prices. Since the 10y3m yield curve has accurately predicted every recession in the past, investors would be wise to follow the “Smart Money.” The “Smart Money” has been moving out of equities and into bonds and they have also been buying gold in anticipation the Fed will be forced to reinstate a zero-interest rate policy. As more recessionary signals trip, it is only a matter of time before the floor falls out of the stock market.

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