Rising Probabilities of a Recession And What You Should Do – Introduction
In the past two months, the amount of volatility in the market has increased significantly. This volatility has seen the VIX index rise from below $15 to the current $25. The VIX was created to measure the amount of fear that traders have in the market by observing the pricing of the options market. Even without the VIX, the volatility is evident with the large swings happening in the market. The chart below shows the performance of key assets.
All this has led many investors to start talking about a correction or even a recession. All this are important things for investors because it would wipe out their gains. For traders like you however, there would be no major implications because your goal is to bet on the direction of the market. While it is not possible to predict when a recession will happen, this article will look at a number of key predictors that Wall Street focuses on.
The most common predictor of when a recession will happen is the yield curve. This is the difference between the longer-term treasury bonds and the short-term ones. In a normal market, the yields of the short-term bonds are usually lower than those of the longer term. This is because of the premium investors ask for when investing in longer-term bonds. Therefore, this curve usually moves up. In recent months, the yield curve has been moving downwards and investors are fearing about higher interest rates. In case the yield curve inverts, it will mean that chances of a recession will be higher.
In the past two years, the Federal Reserve has been in a tightening mood. The bank has tightened by 25 basis points once per quarter. In the past, most recessions have happened at a period when the Federal Reserve is tightening. This is probably the reason why the Fed chair sounded a bit dovish two weeks ago when he addressed the Economic Club of New York.
Mergers and Acquisitions
Mergers and Acquisitions (M&A) are indirect indicators of recession. In M&A, large companies usually acquire the smaller ones. In recent years, the number and size of deals have increased. For example, recently, Dow and Dupont have merged, Microsoft has acquired LinkedIn, Amazon has acquired Wholefoods, and IBM has announced that it will acquire Red Hat. The size of deals is currently at all time highs. They have been fueled by low interest rates and the tax cuts. When they happen in large numbers, they can point to more pain in the market as the deals starts to disappoint.
In months before a recession happens, the economic data tends to start disappointing. In recent months, data from the developed countries have been disappointing. This is more important in the US where the housing market has started cooling down. Similarly, inflation, jobs, consumer confidence, and manufacturing data has been cooling down. The same is true in Europe, China, Japan, and other developed countries. At the same time, the emerging markets are not at ease as higher interest rates raise their borrowing costs.
While no one can predict accurately when a recession will happen, these numbers are important and should be taken seriously. As a trader, you should do the following. First, you should avoid overnight trades. Second, you should size your trades appropriately. Third, you should have a stop loss for all your trades.