For the Longest Period on Record, the Bond Market is Sounding a Recession Alarm. What That Might Mean for the Stock Market.

Since 2022, a widely-watched bond-market indicator of an impending recession has been signaling danger continuously, marking the longest period on record. However, historical data suggests that an “inverted” Treasury yield curve does not necessarily spell immediate trouble for the stock market. Analysts at Verdad Advisers propose that this time might be different for equities.

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Greg Obenshain, a partner and director of credit at Verdad, noted that equity investors typically become very cautious when an inverted yield curve starts to steepen, as this often coincides with negative equity returns. This is because Federal Reserve rate cuts usually indicate a response to an economic downturn. However, in the current scenario, the central bank is considering rate cuts to achieve a soft landing for the economy, rather than responding to an economic decline, which has shown continued growth.

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Obenshain suggested that the yield curve might remain inverted for an extended period or steepen very slowly without triggering significant economic consequences. He based this on earlier research by Verdad, which examined how safe havens in global financial markets typically perform during and after yield-curve inversions. According to Chris Satterthwaite, a senior analyst at Verdad, U.S. equities, especially utilities, real estate stocks, and government bonds, tend to perform better during yield-curve inversions as investors grow more pessimistic about the economic outlook.

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Historical data from Capital IQ and Bloomberg, cited by Satterthwaite, indicates that U.S. equities have been among the best performers when the spread between long-term and short-term Treasury yields was inverted since 1996. However, riskier assets like small-cap stocks and emerging-market equities tended to do better when the yield curve steepened, reflecting increased investor optimism about the economic future.

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An inverted yield curve typically happens when long-term Treasury yields fall below short-term yields, which is contrary to the usual upward-sloping yield curve where longer-term rates are higher due to the greater risk over time. For decades, the spread between 10-year and 2-year Treasury bonds or between 10-year and 3-month rates has been a reliable recession predictor, often preceding downturns since the 1960s. Despite the prolonged inverted yield curve this time, the U.S. economy has not yet experienced a significant slowdown. This is occurring even as the Federal Reserve keeps its short-term policy rate at a 20-year high.

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Despite expectations that the central bank will not change rates following its two-day meeting, strong job growth in May and a historically low unemployment rate suggest no immediate economic crisis. Typically, a steepening yield curve signals a cloudy economic outlook, leading the Fed to cut rates. While stocks often rally with easier monetary policy, they tend to lose those gains if a recession occurs.

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Nanette Abuhoff Jacobson, a global investment strategist at Hartford Funds, mentioned that the traditional predictive power of an inverted yield curve has not held up during this cycle. Factors like robust government and consumer spending post-COVID, along with enthusiasm for artificial intelligence, have helped keep the U.S. economy from recession. This year, U.S. stocks have performed notably well, with major technology shares driving benchmark indexes to new highs. According to TradeAlgo data, the S&P 500 real-estate sector has been the worst performer among the index's 11 sectors, while utilities have surged, boosted by interest in AI after a lackluster 2023.

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For defensive stocks to outperform the broader market during yield-curve inversions, Abuhoff Jacobson stated that a sequence of events leading to a recession is necessary. Such events include prolonged restrictive Fed policy, squeezed earnings, or an unemployment rate rising above 4.5%. She expressed skepticism about this unfolding in the next 12 months.

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On Tuesday, the 2-year Treasury yield fell by 5.1 basis points to 4.832%, and the 10-year Treasury yield dropped by 6.5 basis points to 4.403%, according to FactSet. U.S. stocks closed mostly higher as investors anticipated the May consumer-price index report and the Fed's interest-rate decision. The Nasdaq Composite gained 0.9%, led by Apple Inc., while the S&P 500 rose 0.3% to another record close, though the Dow Jones Industrial Average ended 0.3% lower.

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