How To Predict A Recession: Yield Curve Analysis & The Bond Market
Hi, Robert A. Bonavito. New Jersey forensic accountant here today. Today I'm gonna go a little bit off topic. I'm gonna talk about something that was taught to me by a hedge fund manager many, many years ago. And what this is is a technique in order to predict and understand what's going on in the economy, but also time investments and understand at a much deeper level what's gonna happen in the future, what's gonna happen in two years, what's gonna happen three years, in five years in the economy. And this technique I call, "fear the yield curve." And the reason I use that name is because the yield curve reflects bond prices and if you look at how bonds fluctuate, the prices of bonds fluctuate, they go up and down based on demand. Now, I'm gonna just take a second here to explain this a little bit deeper, but it's like any other price. And the reason why the fluctuation in bond price is powerful is because you can tell a lot by what people are thinking by the actions of the bond. And for example, let me just go into a little bit detail of how a bond works. If people are trying to buy a bond, lots of people are buying a bond, it's just like anything else, like houses or cars. If more people want it, the price goes up. But when the price of the bond goes up, that means that the interest rate goes down because people are paying more for the bond. So, there's an inverse relationship and if you think about it, it makes sense. More people buy it, the bond price goes up, interest rate goes down, inverse relationship.
And so what that's telling you is if everybody is buying a bond or 2-year bond or a 10-year bond, well, what's gonna happen? Those rates are gonna go down and that's gonna tell you something is happening in the economy and there is a terminology for this, it's called "wisdom of the crowds." Why many people are smarter than a few and how collective wisdom shapes businesses, economies, societies, and the nation. So, you have millions and millions of people buying this bond minute by minute, you can just go look and see what that bond is selling for and that will tell you how people are feeling. For example, let's say...and smart people buy bonds. It's not like stocks. Smart people buy bonds. Let's say that these people, millions of people feel that the economy is gonna have issues. What do they do? Well, they look at a 10-year bond and they say, "Yeah. I'm gonna start buying the bond." Well, the people selling you a 10-year bond are gonna say, "Hey, everybody wants to buy my 10-year bond all of a sudden. I'm gonna raise the price." Interest rates go down.
Now, at the same time, there's two-year bonds. What's happening with the two-year bond? Well, maybe that's going down too a little bit, but more people want, if they think there's gonna be a bad recession coming, they want the 10-year bond. They wanna lock those interest rates in for 10 years, not 2. But I would expect to see some activity in the 10-year bond too. Now, I know I promised you, I'm gonna go through this in detail. So, you can have a really good understanding. And two websites that you may wanna become familiar with, and I'm gonna actually go on these websites and show you what I'm talking about is the first one is the Federal Reserve and there's a publication called H.15. This is a great publication because it gives you interest rates, it tells you what the prime rate is, a 2-year bond yield, a 10-year bond, by all kinds of good stuff on here. If you're doing anything, buying a house or a car, you may wanna become familiar with this H.15. And then I'm gonna go in and use this data to show you how we predict the recessions and how you can predict the recession or if things are gonna go better in the future, how you can predict that too. You can actually go and do this.
Now, the first thing I'm gonna do is, this is from the H.15, okay? And you could see here that it lists bonds right here and you could see that it has a two-year bond. And you're saying for April, this is 2019, the bond is yielding 2.4%. They call that basis points. And the 10-year is 2.56. Now, you can see there's a difference between these two bonds. If you buy a 10-year, you're gonna get a little bit more, you're gonna get 2.56 where if you buy a 2-year, you're gonna get 2.40. And so the difference between these two bonds is what? It's 16 basis points. Meaning that if you lock your money up for 10 years, you're gonna get 16 basis points. Now, it's a little scary, right? Because people are buying this bond. Obviously, the price is going up and the yield's going down. And if this inverts, let's say that this rate went down to 2.30, which means the 10-year bond is paying less than the 2-year. Well, that's called inversion, and that's one of the signals that something is wrong because you should never have a 10-year bond rate that's lower than a 2-year because think of all the risk involved in holding money for 10 years. And if people are willing to do that, this wisdom of the crowds are saying, "Hey, wake up. Something is going on." And this is an easy sign to see is this publication, I'm actually online. You could see right here, you could see that I'm on this H.15 and this is what it looks like. This is the whole website. You could see there's some really interesting stuff on here. Inflation index bonds, if you're a prime loan rate, commercial paper. This is...if you're buying a house or buying a car, it's something you really should be familiar with.
Now, let's go over and see. We talked a little bit about, and again this is as of today when I'm doing this. But you could see here that at this point, the two-year is 2.31, 2.52. Okay. So, that is now 21 basis points, this means the spread increased, meaning people are feeling better. Before, I think we said it was 16 basis points. But now let's take a look at how we can use this data by simply taking the 2-year yields and a 10-year and subtracting them and plotting them. Okay. Let's look at where this was done. Here it is. So, here is an analysis that we did. It subtracts the 10-year maturities minus the 2-year. And we're gonna see what this is telling us. Like I said, when you do these, it should give you some information. I'm gonna do the max, which is 43 years from 1976 to 2019. I'm gonna analyze the changes in the bond yields. Remember, I'm just gonna take the 10-year and subtract the 2-year from it. And let's see what happened over this period. You could see over here, in 1977, obviously, the 10-year was about 1% higher or more, 1.4% higher. And then look what's happening here. This is 1978, the yield inverted. This is telling you that the 2-year yield is higher than the 10 by 0.69. Something is wrong. So, hopefully, in 1978 if you were around like I was, you knew something was wrong and I knew something was wrong.
So, what happens? We have a recession here, in 1980. Look what happens, it goes back up. Ten-year yield is higher than a two. Then it dips down. And what happens? This is saying, what is this telling you? The yield is inverting. Guess what happens? Another recession. We're going along, everything is fine. Boom. 1989. Okay. The great real estate recession right here. We're having a great time. Not so good. Yield inverts. What happens? A recession. Okay. Back to having a good time. This is really a good time, 2003. Right? Everything is going on, some real estate issues. This is called the great recession. One of the worst economic classes in the history of the United States. And there's a handful of people that knew it was coming. And if you're smart, what are you doing here? The yield is inverting, sell real estate. Start selling stocks, buy bonds. Okay. Bingo. And now here we are. This is what's going on right now. Look. And we just looked at some of the yields. You can see it's almost inverting. I was really nervous in March. That thing almost inverted. And that's giving you a great sign there that there's a recession. But I really think it needs to go into negative territory. So, hopefully, that does not invert.
So, this was a quick summary of something that I think you should be aware of. We use it for all kinds of stuff because we do a lot of litigation, as everybody knows, we go to court all the time, we do projections for companies, what's gonna happen to this company in the future. And what I do is that this is one of the things we look at because if I think we're heading towards a recession like we did back here, I am not going to say the company is gonna do great. But if things are humming along like they were over here, well, that's a good sign. And we think that the company is not gonna be adversely affected. Of course, our clients, if they ask us what we think about the economy, I'm like, "Well, I think the yield is gonna invert." They're like, they don't understand what I'm saying. So, I'll send them to this video. So, listen, guys. If you have any questions on this video, just leave a comment in my YouTube and I'll get back to you. But I hope you enjoyed this one. Thanks for listening.