Could this be the warning sign of a recession?

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08/28/2018 | 03:23 pm
The current narrowing gap between short-term and long-term borrowing costs could be signaling an impending recession, the San Francisco Federal Reserve Bank said in a new study.

The S&P 500 already broke its record for the longest bull market. We all know this can’t go on forever, and many of us are starting to wonder when the next recession will hit us. A new study from the San Francisco Federal Reserve Bank might be cause for concern.

It said the gap between long-term and short-term Treasury yields is narrowing, and when long-term rates drop below short-term rates, it is generally followed shortly afterward by an economic recession.

(Source : "Information in the Yield Curve about Future Recessions", Federal Reserve Bank of San Francisco)
The graph shows the evolution since 2000 of three spreads - the difference between the ten-year and three-month Treasury; the ten-year and 2-year Treasury, and between the six-quarters-ahead forward rate and the three-month yield (forward6q–3m). “They typically drop below zero, indicating an inversion of the yield curve, about a year or two before the onset of a recession”, the study states. Most recently, the long-term spreads have both continued their decline. The San Fran Fed notes that the traditional 10y–3m spread is the most reliable predictor.

Signs of hope

However, not everybody agrees that the long spread is the best indicator. We can see on the graph that the short-term spread has increased over the past year, which could mitigate the recession risk, according to Eric Engstrom, the U.S. Board of Governors of the Federal Reserve System, and Steven A. Sharpe, from the Federal Reserve Board. They said in a June note that, for predicting recessions, such measures of a "long-term spread" are statistically dominated by a more economically intuitive alternative, a "near-term forward spread."

And although the San Francisco Federal Reserve Bank states that the recent evolution of the yield curve suggests that recession risk might be rising, it still notes that the flattening yield curve provides no sign of an impending recession, as the evidence suggests that recession predictions based on the yield curve require an inversion. While this spread has narrowed recently, it is still a comfortable distance from a yield curve inversion.
Romain Fournier
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