Traditionally, it is common to consider yield curve inversion (in the classical sense, the negative difference between 30-year and 2-year US bonds) as an indicator of a recession warning, but let’s transform the formula a bit this time.
The point is that yield curve inversion reflects the difference between short-term and long-term bond yields based on fundamental economic factors such as inflation, monetary policy and investors’ expectations of future economic growth. However, it does not reflect emotional or psychological aspects that may influence the behavior of market participants.
In order to reflect the relationship of the yield curve to the U.S. market (in this case, we take the SPX index as a benchmark for the U.S. market), we modify the formula as follows:
(US02Y-USD30Y) / SPX
Where:
- US02Y — yield on 2-year U.S. Treasuries,
- US30Y — yield on 30-year US Treasuries,
- SPX — S&P 500 index
On the graph we will highlight three main zones: the dot-com crisis, the mortgage crisis and the current state. Also on the chart we have an important level of 0% (red horizontal line). Analyzing the previous major economic recessions, we can see that the indicator first breaks this level, then forms a local extremum, and after a repeated decline below 0%, the crisis scenario begins. In the case of the dot-com crisis, the period from the local high to the low took 1008 days, and in the case of the mortgage crisis it took 1183 days. At this point, 581 days have passed since the last local high, indicating that we are now halfway down the dangerous path.