The curve that predicts RECESSION
Recession — The dreaded word which has affected the human race numerous times in the past, is again expected to be around the corner. Less than 2 and a half years since the last recession ( due to the pandemic ), the US economy is looking at the abyss of the dreaded R- word again.
Be it the great depression of the 1920s which was preceded by the World War 1, the numerous recessions in the later half of the 20th century which were fueled by the cold war and rising oil crisis, to the dot-com bubble ( and the 9–11 attacks ) at the turn of the century which brought an end to a decade of growth, to the Great recession in 2007–09 which led to the collapse of US housing bubble and finally the COVID-19 recession, each recession in the recent history has been succeeded by massive financial crises, inflation, rise in the unemployment rate and an overall contraction in the economy.
But how is a recession defined? is it the fall in the domestic stock market, or a steep rise in unemployment rate, or lowering in the valuation of a GDP. In short, a recession can be defined as two consecutive quarters when the economy shrinks ( instead of growth), which is popularly measured through Gross Domestic Product or GDP.
Looking at the graph which shows the GDP growth in India from 1985–2020.
It is visible that the GDP growth rate dips below 0 in 2020 ( amidst the pandemic). This dip can be characterized as a ‘Recession’. It’s also interesting to note that India has been resilient to past recessions ( notably the dot-com bubble burst and Recession of 2007).
Predicting a Recession
The US Department of treasury issues Treasure Bond (or T-bond) to fund the government’s activities. T-bonds are a risk free way for individual investors for long term investments such as retirement funds or children’s education. How this T-bond yield ( interest rate ) changes over the different durations of investment which ranges from a month to 30 years can be plotted on a graph known as ‘The Yield Curve’. This graph is generally an upward trending graph, which shows lower interest rates at shorter durations and higher interest rates for longer durations.
Logically this seems correct, longer the duration, more the risk involved, therefore higher the yield. At times, the shape of the curve can invert ( or a downward slope) which signifies higher yield in short terms as compared to longer durations.
When the economy is uncertain and there is a chance of a digression in the growth, investors shift their money from short term bonds to long term bonds by selling off their short term bonds. This increases the demand of the long term bonds which also increase their prices. As the yield is inversely related to the bond prices, the yield of these long term bonds decrease. This also causes a lower demand of short term bonds which leads to rise in their yields.
This leads to an ‘Inverse Yield Curve’ which has been used to predict upcoming recessions in the US Market. This decrease in the demand of short term bonds have been typically associated with recessions.
Every recession in the past 40 years has been preceded by a Yield curve inversion, but not every yield curve inversion has led to a recession.
Impact of Inverse Yield curve on Equities
Companies which tend to borrow money in the short term and lend money for long term are the ones which are most adversely affected by the inverse in yield curve which includes banks and other financial corporations.
On the other hand, companies from food stables, healthcare and FMCGs are expected to be resistant from the inversion as they are less interest dependent.
Also, when a recession hits, investors tend to go for these ‘defensive stocks’ which signifies that these stocks are less affected by economic downturns.
Is a recession imminent?
The 2nd Quarter of 2022, has seen the yield curve to inverse ( for the first time post pandemic ).With the war in Europe showing no signs of end, the high inflation in the US, decline in the mortgage demand and a 23% decline in the S&P500 index in the past year , economists predict US might be heading for a possible recession.
Comments
Post a Comment