Deep Dive: What Causes a Recession — The Key Economic Indicators Every Investor Should Watch

No single indicator has a better track record of forecasting recessions than the yield curve — specifically, the spread between the 10-year and 2-year U.S. Treasury yields. When this spread turns negative (a "yield curve inversion"), it means short-term rates exceed long-term rates, signaling that bond markets expect economic weakness ahead. Every U.S. recession since 1955 has been preceded by a yield curve inversion, with only one false positive in the mid-1960s.

The mechanism is straightforward: when investors expect a slowdown, they pile into long-term bonds for safety, driving down long-term yields. Meanwhile, if the Federal Reserve is keeping short-term rates elevated to fight inflation, the short end stays high — and the curve inverts. The inversion itself can also contribute to a slowdown by squeezing bank lending margins, since banks borrow short and lend long.

As of February 2026, the 10-year Treasury yield stands at 4.08% while the 2-year yield is 3.47%, producing a positive spread of 0.60 percentage points. This marks a significant shift — the yield curve was deeply inverted through much of 2023 and 2024 before normalizing in late 2025. Historically, recessions tend to begin 12-24 months after the initial inversion, and the curve often steepens back to positive territory before the downturn actually arrives. For a deeper look at what today's yield curve shape means for bond investors, see our [Treasury yield curve analysis](/posts/2026-02-21/treasuries-the-yield-curve-has-normalized-after-two-years-of-inversion-what-the-60-basis-point-spread-signals-for-bonds-the-fed-and-your-portfolio).

The labor market is the backbone of the U.S. economy — consumer spending accounts for roughly 70% of GDP, and consumers can only spend if they're employed. Two employment indicators deserve particular attention: the unemployment rate and initial jobless claims.

The Sahm Rule, developed by former Federal Reserve economist Claudia Sahm, provides a precise trigger: a recession is likely underway when the 3-month moving average of the national unemployment rate rises by 0.50 percentage points or more from its low over the previous 12 months. This rule has identified every U.S. recession since 1970 in real time, with no false positives.

Currently, the U.S. unemployment rate is 4.3% as of January 2026, down from a recent high of 4.5% in November 2025. The 12-month low was 4.0% in January 2025, meaning the rate has risen 0.30 percentage points from trough — below the 0.50% Sahm Rule threshold but moving in a direction that warrants monitoring. Meanwhile, initial jobless claims remain historically low at 206,000 for the week ending February 14, 2026, well below the 300,000 level typically associated with labor market stress.

Gross Domestic Product is the broadest measure of economic health, capturing the total value of goods and services produced. While GDP is a lagging indicator — it's reported quarterly and frequently revised — its direction tells investors whether the economy is expanding or contracting. Two consecutive quarters of negative real GDP growth is the commonly cited (though unofficial) definition of a recession.

U.S. nominal GDP reached $31.49 trillion in Q4 2025, up from $30.04 trillion in Q1 2025 — representing continued expansion throughout the year. Quarterly nominal growth ran at roughly 1.0-2.0% per quarter through 2025, which after adjusting for approximately 2.2% annualized inflation, suggests real GDP growth of roughly 2.5-3.0% annualized. This is solid by historical standards and well above the contraction territory that would signal recession.

Industrial production, tracked by the Federal Reserve's INDPRO index, offers a more timely and granular view of the goods-producing sector (manufacturing, mining, and utilities). The index stood at 102.34 in January 2026, up modestly from 101.10 a year earlier — a gain of about 1.2%. While not booming, this slow but steady expansion is inconsistent with recession. Sustained declines in industrial production — typically 3-5% from peak — have accompanied every post-war recession. The current data shows no such deterioration.

Consumer sentiment is both a cause and consequence of recessions. When consumers feel pessimistic about the future, they pull back spending, which slows the economy, which makes them more pessimistic — a self-reinforcing cycle. The University of Michigan Consumer Sentiment Index is one of the longest-running and most-watched measures of this psychological dimension.

The data paints a mixed picture. Consumer sentiment dropped from 64.7 in February 2025 to a low of 51.0 in November 2025 before rebounding to 56.4 in January 2026. This decline coincided with rising uncertainty around trade policy, tariff impacts, and persistent (though moderating) inflation. Readings below 60 have historically been associated with periods of economic stress, though not every dip below that threshold leads to a recession.

On the inflation front, the Consumer Price Index stood at 326.59 in January 2026, up from 319.68 a year earlier — implying year-over-year inflation of approximately 2.2%. This is close to the Fed's 2% target and well below the 9%+ readings of mid-2022 that initially sparked recession fears. Moderating inflation gives the Federal Reserve room to cut rates further if the economy weakens, which is itself a recession buffer. For more on how the Fed uses monetary policy tools to manage economic cycles, see our [central banking explainer](/posts/2026-02-22/deep-dive-how-central-banks-control-the-money-supply-from-interest-rates-to-quantitative-easing).

The Federal Reserve's interest rate decisions serve as both a leading indicator and a policy response. When the Fed cuts rates, it signals concern about economic weakness. The question investors must answer is whether the cuts are "insurance" cuts (preemptive moves to sustain growth) or reactive cuts in response to a deterioration already underway.

The Fed has cut the federal funds rate from 5.33% in August 2024 to 3.64% in January 2026 — a total reduction of 169 basis points over roughly 16 months. The pace of cutting has been measured: 50 basis points in late 2024, followed by gradual reductions through 2025 and into 2026. This pattern more closely resembles the 1995 "soft landing" cycle (where rate cuts successfully averted recession) than the aggressive emergency cuts of 2001 or 2008.

Critically, the Fed still has significant ammunition — with rates at 3.64%, there is substantial room for further cuts if the economy deteriorates. Compare this to the near-zero rates during the COVID-19 recession, when the Fed had to resort to unconventional tools like quantitative easing. The current rate environment gives policymakers flexibility. For more on the transition in Federal Reserve leadership and what it means for policy direction, see our [analysis of the Fed chair transition](/posts/2026-02-21/analysis-kevin-warsh-and-the-fed-chair-transition-what-a-new-central-bank-leader-means-for-markets-rates-and-the-economy).