What stock investors need to know about the bond market recession signal

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Blink and you missed it, but the yield on the 2-year Treasury briefly traded above the yield on the 10-year note on Tuesday afternoon, temporarily inverting the yield curve and triggering warnings of recession.

The data shows that it hasn’t paid off in the past to drop out of stocks as the Treasury yield curve turns, with short-term yields outpacing long-term yields.

Not a good timing tool

“While a good indicator of future economic difficulties, an inverted yield curve has not been a very good timing tool for equity investors,” wrote Brian Levitt, global market strategist at Invesco in a note to the March 24.

To see: A key part of the Treasury yield curve has finally inverted, triggering a recession warning – here’s what investors need to know

“For example, investors who sold when the yield curve first inverted on December 14, 1988, missed out on a subsequent 34% gain in the S&P 500 Index,” Levitt wrote. “Those who sold when it happened again on May 26, 1998 missed out on another 39% upside for the market,” he said. “In fact, the median return of the S&P 500 from the date of each cycle when the yield curve inverts at the top of the market is 19%.” (See table below.)

Invesco


Investors certainly didn’t head for the hills on Tuesday. US stocks ended with strong gains, building on a rebound from early March lows and even propelling the S&P 500 SPX,
-0.63%
to an exit from the market correction it entered in February. The Dow Jones Industrial Average DJIA,
-0.19%
jumped 338 points, or 1%, while the Nasdaq Composite COMP,
-1.21%
advanced by 1.8%.

Read: S&P 500 breaks out of correction: Here’s what history says is happening next to the US stock market benchmark

Shares ended lower on Wednesday.

Inversions and what they mean

Normally, the yield curve, a line that measures returns across all maturities, slopes upward given the time value of money. An inverted curve signals that investors expect longer-term rates to be lower than short-term rates, a phenomenon widely seen as a signal of a potential economic slowdown.

But there is also a lag. Levitt noted that data, dating back to 1965, shows the median duration between a reversal and a recession was 18 months, which is the median stretch between the start of a reversal and a peak in the S&P 500.

Additionally, the researchers argued that a persistent reversal is needed to send a signal, which has not yet happened, but is still widely expected.

What curve?

A reversal of the 2-year TMUBMUSD02Y,
2.298%
/10 years TMUBMUSD10Y,
2.343%
Yield curve measurement has preceded all six recessions since 1978, with just one false positive, Ross Mayfield, an investment strategy analyst at Baird, said in a Monday note.

But the 3-month/10-year spread is considered even, if only slightly, more reliable and has been more popular among academics, researchers noted. at the San Francisco Fed. Some economists say the Fed’s bond-buying program has artificially held down long-term yields, distorting the yield curve signal.

And Fed Chairman Jerome Powell earlier this month expressed a preference for a more short-term metric that measures 3-month rates against expectations for 3-month rates 18 months from now.

The 3-month/10-year gap, meanwhile, is “far from being reversed,” Mayfield noted.

To see: Stock investors should watch this part of the yield curve for the ‘best leading indicator of trouble ahead’

Indeed, the divergence between the two metrics closely followed on the curve has been a headache for some market watchers.

“What is remarkable is that the two always went together in direction until around December 2021, when 3m/10s started to steepen as 2s/10s fell apart,” said Jim Reid , strategist at Deutsche Bank, in a Tuesday note (see chart below). ).

German Bank


“There has never been such a directional divergence, perhaps because the Fed [has] have never been so late as they are today,” said Reid. “If market prices are correct they will catch up quickly over the next year, so it is possible that in 12 months” the 3-month/10-year measure will be flat as short-term rates rise as the Fed raises its benchmark. key rates.

Mark Hubert: Stop panicking over the inverted yield curve – chances of a recession are still low

The bottom line, Mayfield wrote, is that the yield curve remains a powerful indicator and at the very least signals a cooling economy.

“Volatility should remain high and the bar for investing success is raised. But at the end of the day, we think it’s worth taking the time to digest the bigger picture and not rely to a single indicator,” he said.

In a chart: ‘The Dam Has Finally Burst’: 10-Year Treasury Yields Peak to Break Top of Downtrend Channel Seen Since Mid-1980s

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