The bond market is sounding its most severe alarm in decades, and it could spell trouble for the stock market – Yahoo Finance

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The bond market is sounding its most severe alarm in decades, and it could spell trouble for the stock market – Yahoo Finance

The U.S. economy grew 2.5% last year, an acceleration from 2022’s rate of 1.9% and above the 10-year average of 2.3%. This economic dynamic has sent the reference S&P500 (INDEXSNP: ^GSPC) up 24% in 2023, its third best annual performance in the last decade.

Few people saw it coming. After inflation hit a four-decade high in 2022, the Federal Reserve compensated by raising interest rates at their fastest pace in decades. Many economists initially thought this would lead to a recession in 2023. But that recession never happened and the consensus now calls for a soft landing, a scenario in which inflation normalizes without an economic slowdown.

Indeed, the economists questioned by The Wall Street Journal As of April 2024, the odds of a U.S. recession were estimated at 29%, down significantly from 61% in April 2023. However, a popular bond market indicator with a near-perfect track record still draws the odds. alarm bells: 10-year and 3-year bonds. One-month Treasury yields have been inverted since November 2022, which could spell trouble for the stock market.

Here’s what investors should know.

Treasury yield curve issues recession warning

Treasury bills are debt securities issued by the federal government. They pay a fixed interest rate until maturity, which varies from one month to 30 years, at which point the bond holder gets back the principal invested.

The interest rate (or yield) on debt securities generally increases as the maturity lengthens, meaning that a 10-year Treasury normally pays more than a 3-month Treasury. As such, the yield curve – a graphical representation of interest rates on Treasury bills of different maturities – normally slopes upward and to the right. But the yield curve inverts when a long-term Treasury pays less than a short-term Treasury.

Yield curve inversions can occur when investors worry about a recession. To be more specific, some investors prefer to hold long-term Treasury bonds (which offer risk-free returns) rather than stocks or other risky assets during periods of economic uncertainty. Bond prices and yields move in opposite directions. So, with enough buying pressure, long-term Treasuries can end up paying less than short-term Treasuries, creating an inversion of the yield curve.

The duration spread between the 10-year and 3-month Treasury bonds – that is, the 10-year Treasury rate minus the 3-month Treasury rate – is of particular interest to investors because it predicted past recessions with near-perfect accuracy. In fact, the yield spread has turned negative (signaling an inversion of the yield curve) before every recession since 1968.

This chart shows the start of each yield curve inversion and subsequent recession since 1968.

Start date of yield curve inversion

Recession start date

Time elapsed

December 1968

December 1969

12 months

June 1973

November 1973

Five months

November 1978

January 1980

14 months

October 1980

July 1981

Nine months

June 1989

July 1990

13 months

July 2000

March 2001

Eight months

August 2006

December 2007

16 months

June 2019

February 2020

Eight months

November 2022

Unknown

17 months (and counting)

Data source: National Bureau of Economic Research, Federal Reserve Bank of New York. Note: The yield curve inversion dates correspond to the first month during which the average term spread was negative.

As the table shows, the U.S. economy has experienced eight recessions since 1968. The Treasury yield curve inverted before each one, and the inversion began no more than 16 months before the recession. This means that the current situation is somewhat unique for two reasons.

First, the 10-year and 3-month Treasury yields have been inverted for 17 months (and counting) without a recession, which hasn’t happened in at least 56 years. Additionally, the average yield spread in March 2024 was minus 1.17%, the lowest reading (excluding the current inversion) since negative 1.43% in August 1981. This means that the yield curve is more sharply reversed than it has been for four decades.

In short, the bond market isn’t just sounding the alarm: it’s sounding the most serious recession alarm since 1981.

The stock market has performed poorly in past recessions, but it has also recovered quickly.

No forecasting tool is perfect. The 10-year and 3-month Treasury rates effectively reversed in 1966, with no subsequent recession. Additionally, although the June 2019 inversion was followed by a recession in February 2020, this downturn was caused by COVID-19. The bond market can’t predict global pandemics, so the reversal could be a coincidence.

However, if the current yield curve inversion does indeed signal a recession, history says the stock market will fall sharply. The chart details the maximum decline of the S&P 500 during each recession since 1968.

Recession start date

S&P 500 peak decline

December 1969

(36%)

November 1973

(48%)

January 1980

(17%)

July 1981

(27%)

July 1990

(20%)

March 2001

(37%)

December 2007

(57%)

February 2020

(34%)

Average

(34.5%)

Data source: Truist Advisory Services.

As noted, the S&P 500 Index has declined an average of 34.5% during recessions since 1968. This sounds alarming, but readers should keep two things in mind.

First, there is no guarantee that a recession will follow the current yield curve inversion. The bond market could sound a false alarm. Second, the stock market is forward-looking in nature, so the S&P 500 has historically recovered four or five months before recessions end, depending on JPMorgan Chase.

The stock market has also rebounded quickly in the past. After hitting its peak decline during the last eight recessions, the S&P 500 returned an average of 42% over the following year. In this context, it would be very risky for investors to sell stocks now to protect themselves against a possible recession. This strategy could easily backfire because it would be impossible to predict the rebound of the S&P 500.

So even though the bond market is currently sounding its most serious recession alarm in decades, there is no guarantee that a recession will ever materialize. And even if that’s the case, the most prudent course of action is to stay invested, as market timing strategies could lead to missed opportunities.

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JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Trevor Jennevine has no position in any of the securities mentioned. The Motley Fool holds positions and recommends JPMorgan Chase and Truist Financial. The Motley Fool has a disclosure policy.

The bond market is sounding its most severe alarm in decades, and that could spell trouble for the stock market. was originally published by The Motley Fool

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