Winter is coming. (ETF: TLT & VCLT)

 

In this research report, I recommend preparing for a potential recession in the coming months or years by investing in the debt market. Even if a recession is avoided and we achieve a soft landing, debt market investments will remain effective because the Federal Reserve will likely need to lower interest rates to prevent a downturn. Furthermore, the CPI has just come inside the target boudary of the central bank.

U.S. Base Interest Rate

It's been a few months since the Federal Reserve halted increasing the base interest rate, which indicates that prices are under control. Raising interest rates is one of the most common methods to cool down an overheated economy. An overheated economy accelerates inflation, making it difficult for people to purchase goods at stable prices.

 

While raising interest rates might seem beneficial, it also has significant side effects. As rates increase, companies and business owners are forced to borrow money at higher costs. Additionally, customers are more likely to deposit their money in banks to earn higher interest, leading to reduced consumer spending. This decrease in spending can shrink the market and reduce money flow, potentially triggering an economic recession.

 

To prevent or address a recession, the Federal Reserve typically lowers interest rates to inject liquidity back into the market. This encourages consumers to invest and spend, stimulating economic activity and helping to revive the market. While we may not be able to precisely predict the timing of these rate cuts, we can anticipate long-term trends and seize the opportunity to invest accordingly.

 

 

Here are the three main reasons that explain why the US can face economic recession.

 

#1

10 - 2 Year Treasury Yield Spread 

10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity

 

10 Year - 2 Year Treasury Spread Yield

When investors anticipate an economic downturn, they buy long-term treasuries to secure stable income and minimize market risk. This increased demand causes long-term interest rates to decrease, leading to a situation where the rates of short-term and long-term bonds may cross each other and the Yield Spread value( Usually 10 Year Treasury Yield - 2 Year Treasury Yield)  becomes negative. This phenomenon has been observed since the 1970s. When the 10-Year to 2-Year Treasury Yield spread turned positive after being negative, recessions visibly surfaced and people could tangibly feel the economic downturn. This pattern is not scientifically proven, and there is no established causal relationship. It only holds statistical significance.

Dates of U.S. recessions as inferred by GDP based recession indicator

The picture shows the dates of recessions in the U.S. Below, I've overlapped the 10-2 Year Treasury Yield Spread with the dates of those recessions. 

From the picture above, we can see that recessions have always occurred when the yield spread turned positive from negative. Even though the yield spread has only statistical significance, it's important to note that this pattern has consistently occurred and has been a 100% accurate signal.

 

#2

Labor market is shrinking.

Hires: Total Nonfarm

Layoffs and Discharges: Total Nonfarm

 

The first picture above shows that total nonfarm hires have decreased since January 2022, indicating that it is becoming more difficult to find jobs. Meanwhile, from the second picture above, we can see that layoffs and discharges have increased since September 2021. This data indicates that the labor market has shrunk, and consumers no longer have the same purchasing power as they did in the past. As consumers spend less money in the market, companies eventually earn less, which can lead to an economic recession.

 

#3

Increasing Non-Business Bankruptcy

U.S. Bankruptcy Cases Filed

"Total bankruptcy filings rose 16.8 percent, with significant increases in both business and non-business bankruptcies, in the twelve-month period ending Dec. 31, 2023. This accelerates a continuing rebound in filings after more than a decade of sharply dropping totals."

-U.S. Bankruptcy Courts-

 

On January 26, 2024, the U.S. Bankruptcy Courts announced that Non-Business Bankruptcies increased by 16.8% recently. This reflects not only a decline in consumer purchasing power but also that individuals are now losing their entire capacity to pay their bills and debts.

 

Investment Point

• When the economy experiences a downturn, long-term bond prices tend to increase as interest rates decrease. This inverse relationship between bond prices and interest rates means that as rates go down, the value of existing bonds with higher rates becomes more attractive, driving up their prices. (Check the relationship between bond price and the interest rate)
• Even if we achieve a soft landing without a severe recession, the Federal Reserve will still need to lower interest rates to prevent a potential downturn.
• On July 15, 2024, Federal Reserve Chair, Jerome Powell said that the central bank will not wait until inflation hits 2% to cut interest rates. On August 15, 2024, the CPI index fell down to 2.9% and it indicates that the central bank will start to cut the rates in near future.

Even during an economic downturn, it's still possible to make money through investing.

There are always opportunities to profit during a crisis. While the three reasons mentioned above—indicating why the U.S. is likely to experience a recession—do not guarantee a future recession, it’s important to note that the Federal Reserve will eventually have to cut interest rates because prolonged high interest rates can have adverse side effects and may lead to unnecessary recessions that we want to avoid.

ETF: TLT and 10 Year Treasury Yield

When interest rates are expected to fall, investing in bonds becomes a strategic option. Long- term bonds are particularly recommended as they can secure stable long-term income and tend to have more volatile price movements. Take a look at how bond prices respond when interest rates decline. The chart above shows the candlestick chart of ETF: TLT, while the graph below it represents the 10-Year Treasury Yield. Notice how they move in opposite directions, almost like a decalcomania pattern. If you're looking to build a higher interest income portfolio, you might also consider investing in  VCLT.

Ticker and Full Name	TLT: iShares 20+ Year Treasury Bond ETF
NAV as of Aug 13, 2024	$97.23
Expense Ratio	0.15%
Investment Objective	The iShares 20+ Year Treasury Bond ETF seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years.
Why TLT?	1. Exposure to long-term U.S. Treasury bonds 2. Targeted access to a specific segment of the U.S. Treasury market 3. Use to customize your exposure to Treasuries

Ticker and Full Name	VCLT: Vanguard Long-Term Corporate Bond ETF
NAV as of Aug 13, 2024	$78.90
Expense Ratio	0.04%
Investment Objective	The Vanguard Long-Term Corporate Bond ETF seeks to track the investment results of long-term corporate bonds with remaining maturities betweeb 10 - 25 years.
Why VCLT?	1. Seeks to provide a high and sustainable level of current income. 2. Invests primarily in high-quality (investment-grade) corporate bonds. 3. Maintains a dollar-weighted average maturity of 10 to 25 years.

 

 

© Seungyun Nam. All rights reserved. This article and associated reports are shared with the Center of Entrepreneurial Finance (CEF) at Stony Brook University.