Inflation in June came down more rapidly than expected, falling to 3%. Surprisingly, the recession that many analysts had predicted has not materialized, as indicated by the 3.6% unemployment rate, which is nearing a 50-year low, and the S&P 500 Index, which has gained 19% year-to-date.
While the current market performance may lead investors to believe that a recession has been avoided, there are three metrics that have consistently predicted recessions over time. These leading economic indicators serve as key economic variables that tend to move ahead of changes in overall economic activity, providing an early warning system for changes in the business cycle. Let’s delve into three of these indicators and explain how investors can interpret them.
The first indicator is the yield curve inversion, which represents the relationship between short-term and long-term interest rates on government bonds. Normally, long-term bonds have higher yields than short-term bonds to compensate investors for the risk of holding their money for a longer period. Historically, an inverted yield curve has often preceded recessions. This indicator suggests that investors are worried about the near future and expect interest rates to fall due to a potential economic slowdown. Currently, the two-year Treasury yield is 3.25%, while the 10-year Treasury yield is 2.95%, typical of periods ahead of a recession. However, it’s important to note that there is usually a nine- to 24-month lag before the economic contraction takes place.
The second indicator is the Conference Board’s leading economic indicators (LEI), which comprise a variety of data points such as building permits, stock prices, consumer expectations, and average weekly hours worked. When these indicators start to decline or show a negative pattern, it can signal an impending recession. The consumer confidence index for July reached a reading of 117, the highest level in two years. Additionally, the probability of a recession in the next six months, according to The Conference Board, has decreased from 30% in June to 25%.
The third indicator is the purchasing managers’ index (PMI), which is based on five major indicators: new orders, inventory levels, production, supplier deliveries, and the employment environment. A PMI reading above 50 represents an expansion, while readings under 50 indicate a contraction. The S&P Global U.S. Manufacturing PMI fell to 46.0 in July 2023, the lowest reading since December 2022, indicating that the manufacturing sector is in a state of contraction. This slowdown in the global economy is negatively impacting the demand for exports from the United States.
Amidst these mixed signals, the Federal Reserve finds itself in a tight spot. Despite robust consumer demand supported by rising wages and low unemployment, industrial growth indicators have remained weak throughout 2023. Additionally, bond markets indicate a reluctance to add risk-on positions as the Federal Reserve plans to tighten its monetary policy and raise interest rates in 2023. The Fed’s decisions have significant implications, as they could either slow down the economy too quickly, possibly leading to a recession, or trigger high inflation, which can erode purchasing power and destabilize the currency.
For cryptocurrency investors, there is an additional variable that further complicates the analysis. Over the past eight months, Bitcoin (BTC) and the stock market have displayed periods of inverse correlation, meaning that the assets moved in different directions. Amid the uncertainty in the crypto market, the Fed’s decisions are crucial in revealing economic confidence. Increasing interest rates may signify stability, potentially benefiting cryptocurrency markets in the short term, whereas rate cuts could indicate economic concerns that could affect risk-on markets in general. Therefore, tracking the Federal Reserve provides timely guidance for investors in uncertain economic times.
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