By definition, economic recession is a period of at least two consecutive quarters when the economy is in decline.
It is typically accompanied by an increase in unemployment, decline in the housing market and a drop in the stock market – decline in GDP.
Though recession is less severe than a depression, there are still many different factors that are the cause of recession.
While many economists and some traders are arguably versatile in predicting another recession, beginner traders can have difficulties deciding which factors to track.
Can we predict recessions?
The short answer is, yes – I personally think it is possible, at least to a large extent.
Now, let's talk about the key economic indicators when trying to predict the next recession and how to use this information when trading.
This is my favorite economic indicator.
So, how to predict recession with a yield curve?
I will try to explain it in an easy way.
In normal markets, a longer-dated bond should have a higher yield than a shorter dated bond.
If we take a look at US government bonds, we can see a normal yield curve that has rising yields with longer duration.
Longer-dated treasuries or bonds in a normal or positive yield curve means they attach a higher yield than shorter maturing treasuries or bonds.
This is caused by a risk premium.
This risk premium considers the possibility that rates may increase in the future.
Consequently, longer-dated treasuries of bonds might have a higher yield than shorter-dated ones.
Normal yield curve
Duration is the bond's time to maturity.
So as duration increases, the yield increases with it.
The implication of a normal yield curve is that the longer the bond duration, the higher the yield.
Inverted yield curve
An inverted yield curve is usually a sign of recession coming.
This is due to people flocking to longer-dated bonds for safety of returns, causing the price of bonds to rise and the yields to drop.
As longer-dated bonds attract a premium in price, a lower yield may imply that rate cuts are in the near future.
In simple terms, an inverted yield curve can imply a future recession, as it indicates that shorter-term yields are lower than longer-term yields.
This also means that interest rates in the near future will reduce.
Gross domestic product (GDP) is the market value of all goods and services produced within a country in a given period of time.
In economic terms, if GDP declines for two or more consecutive quarters, it is a sign of recession.
Oil supply is directly linked to GDP.
Higher oil prices increase the cost of production of most goods and services, with a chance to cause lower real GDP and higher inflation.
As a consumer, you may already understand the lesser implications of higher oil prices.
To better illustrate it, I will use gasoline example.
Gasoline purchases are necessary for most households.
When gasoline prices increase, a larger share of households' budgets is likely to be spent on it, which leaves less to spend on other goods and services.
Similarly, higher oil prices tend to make production more expensive for businesses, leaving them less assets to invest into other fields.
High interest rates
When interest rates rise, they limit the amount of money available to invest.
In the recent history, the biggest culprits was the Federal Reserve, which would often raise interest rates to protect the value of the dollar.
The Fed also raised rates to protect the gold vs. dollar relationship, which made the Great Depression even worse.
When the prices of different companies, houses or stock markets become inflated beyond their sustainable value, they tend to burst.
That's why we call it "the bubble".
Recession usually occur when the bubble bursts.
Stock markets and currency correlation
The drop in stock markets may also predict recession.
The sudden loss of confidence in investing can create a subsequent bear market, which may drain the capital out of businesses.
Keep in mind that if loans are written off as bad, it actually destroys the supply of the currency...
...which may cause the currency to strengthen too.
Money supply and velocity
Money velocity is the amount of times that money is turned over in a given period.
So when money velocity is high, it means there is a lot of transactions, which is good for economic activity.
Consequently, a drop in money velocity can be a sign of an impending recession.
Here is a good article explaining money velocity in the credit crunch and recession.
Below shows the Dow Jones during the two most recent recessions that happened in the last 15 years.
The first one is the small recession after dot-com bubble and the second one is the recession linked to the global financial crisis.
My personal study has shown that the only lead you get from the stock market is if a significant high is made.
Then, the equities market should keep going lower into the recession.
In both cases, the index price went below the 200 SMA on Weekly TF.
Best Forex indicators for this purpose are 200 SMA plotted on weekly chart, zoomed out with trend line overlay and MACD.
In the picture above, we can see that the first economic downturn started in early 2000s.
This coincides with the collapse of the speculative dot-com bubble and September 11 attacks.
Dow Jones Index dropped significantly.
The subprime mortgage crisis led to the collapse of the United States housing bubble, lasting from December 2007 until June 2009.
It was named the global financial crisis.
Have in mind that recessions usually run their course over time, but the major goal is to make sure that they do not cause a depression.
How to make money during recession and depression
This is what traders should watch for if they want to trade during recession/depression:
- abovementioned economical signs and cues
- weekly timeframe for spotting out technical patterns
- lower timeframes for cherry-picking overbought price
- traders should be following the trend by selling the equities.
Weekly time frames and monthly charts will provide traders with complete look of the price action.
Once the price breaks below trend lines like the 200 SMA with MACD being below 0 line, traders should focus on lower time frames to find better entries.
H4 or Daily time frame have the least noise so they could be suitable for cherry picking the entries.
As with all bearish trends, traders should sell when the price is overbought. If US gets into recession again it would be mainly US equities.
You have to remember, US Economy is largest in the world, and can drag the rest of the world into a recession.
Equities are generally positively correlated, so they tend to fall together in most cases.
Outside US Equities, it is likely to impact the Import partners most.
...China, Canada, Mexico, Japan and Germany in that order…
...and their respective Indices.
This unique correlation table shows dynamic correlation between equity markets.
In a nutshell
Inverted yield curve, reducing money supply and reducing money velocity all point to a possible recession.
Once everything is set in motion, a domino effect prevails, with one outcome causing or worsening another.
When the stock market becomes unstable, businesses become fearful and lay off more workers, leading to greater unemployment.
This vicious cycle generally continues for months.
Technical charts give us a clear picture, with zones and levels where we could place our trade setups.
For some traders, effects of economic recession can even be beneficiary.
Have you ever traded during recession and/or depression?
Feel free to let us know in the comments below.
Cheers and safe trading,