Stock market investors are laughing at the yield curves recession

Stock market investors are laughing at the yield curve’s recession warning – for now. Here’s why.

Blink and you’ve missed it, but the 2-year Treasury bond yield briefly traded above the 10-year bond yield on Tuesday afternoon, temporarily inverting the yield curve and setting off recession warning bells.

Data shows that historically, it hasn’t paid off to abandon equities at the moment when the US Treasury yield curve is being inverted, with short-term yields being higher than long-term yields.

Not a good timing tool

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

See: Investors need to know that a key part of the government bond yield curve has finally inverted, triggering a recession warning

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

Stock market investors are laughing at the yield curves recession


Investors certainly didn’t head for the mountains on Tuesday. US stocks ended with strong gains, building on a rebound from early March lows and even propelling the S&P 500 SPX (+1.23%) to end the market correction it entered in February. The Dow Jones Industrial Average DJIA, +0.97%, rose 338 points, or 1%, while the Nasdaq Composite COMP, +1.84%, gained 1.8%.

Read: S&P 500 exits correction: Here’s what history says is happening alongside the US stock market benchmark

Inversions and what they mean

Normally, the yield curve, a line that measures yields across all maturities, slopes up given the time value of money. An inversion of the curve signals that investors expect longer-term interest rates to be lower than short-term rates, a phenomenon widely seen as a signal of a possible economic downturn.

But even then there is a delay. Levitt noted that data going back to 1965 shows that the median time between an inversion and a recession was 18 months — which is the median time between the start of an inversion and a peak for the S&P 500.

Additionally, researchers have argued that sustained inversion is necessary to send a signal, something that has not yet occurred but remains widely expected.

Which curve?

An inversion in the 2-year TMUBMUSD02Y, 2.322% / 10-year TMUBMUSD10Y, 2.359% reading of the yield curve has preceded all six recessions since 1978 with just one false positive, Ross Mayfield, an investment strategy analyst at Baird, said in a note Monday.

But the 3-month/10-year spread is considered even, albeit marginally, more reliable and more popular among academics, San Francisco Fed researchers found. And Fed Chair Jerome Powell earlier this month expressed his preference for a more short-term metric that measures 3-month rates versus expectations for 3-month rates 18 months out.

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

See: Stock market investors should keep an eye on this part of the yield curve as “the best leading indicator of trouble ahead.”

Indeed, the divergence between the curve’s two closely tracked metrics was a head-scratcher for some market observers.

“The remarkable thing is that the two always went hand in hand until about December 2021, when 3m/10s steepened when 2/10s collapsed,” said Jim Reid, strategist at Deutsche Bank, in a note Tuesday (see graphic below). ).

1648618590 20 Stock market investors are laughing at the yield curves recession

Deutsche Bank

“There has never been a divergence like this, possibly because of the Fed [has] has never been “more behind the curve” than it is today,” Reid said. “If market prices are correct, they will catch up quickly next year, so it is possible that the 3m/10y measure will be flat 12 months from now as short-term rates rise as the Fed raises its benchmark policy rates.

The takeaway, Mayfield wrote, is that the yield curve remains a strong indicator and at the very least signals a slowdown in the economy.

“Volatility should remain elevated and the bar for investment success should be raised. But in the end we think it’s worth taking the time to digest the big picture and not rely on any single indicator,” he said.

In a chart: “Finally the dam has burst”: 10-year government bond yields are rising and breaking through the upper edge of the downtrend channel observed since the mid-1980s