On March 29, Eastern Time, the U.S. 2/10-year Treasury yield curve inverted for the first time since August 2019.
The yield on the benchmark 10-year U.S. Treasury bond broke 2.4% in midday trading, while the 2-year yield approached 2.4%, exceeding the 10-year yield, and the spread narrowed to -0.234 basis points at one point. But then, the yield curve quickly bounced back, with no further inversion.
What’s the relationship between inverted yield curves and recessions?
When short-term bond yields are higher than long-term bonds, it's called an "inverted curve." An inverted yield curve is a typical signal that a recession is coming.
According to institutional statistics, since 1970, there have been 7 inversions, all of which were at the end of the Fed’s interest rate hike. Among them, six times, there have been recessions of varying degrees in the next two years.
Data From Wind, Made by Capital Insights
On average, since 1980, the average lead time from inversion to recession has been 13 months, with an overall range of 7 to 21 months.
Clearly, recessions certainly do not occur immediately after inversions; in fact, the longest post-inversion, pre-recession time period lasted seven quarters.
So, does this latest yield curve inversion really signal that the economy is heading for a recession?
Fed Chairman Jerome Powell doesn't think so. He pointed out that it is more reasonable to focus on the short-end yield curve, and the gap between the forward implied yield of 3-month U.S. Treasury bills and the current 3-month Treasury bill yield is still widening, indicating that the risk of recession is low. At the same time, he also stressed several times that if necessary, the pace of interest rate hikes will still be accelerated. The inversion of the curve is only a reference indicator, and the specific time of the recession is unknown.
Below we have compiled the views of 11 institutions on bond yield inversion:
1. Stay bullish - the stock market is expected to peak in about a year after the curve inversion
JPMorgan analyst Marko Kolanovic believes stocks could continue to rise despite a hawkish Fed and an inverted U.S. Treasury yield curve spooking investors.
Since 1977, there have been eight yield curve inversions. The S&P 500's average return in the following year was +11.5%, with dividends +15.2%.
Inversions are not a signal to fade stocks.
Mislav Matejka, another analyst at JPMorgan, is also optimistic about the trend of U.S. stocks. In most cases, recessions follow a curve inversion indicator, with an average lag of 16 months, he wrote in the report. And in the period between an inverted curve and a recession, stocks tend to outperform bonds. Historically, stocks have peaked about a year after Treasury yields inverted.
Piper Sandler's research report also supports this view, and their statistics show that stocks and bonds tend to perform well in the window between the inversion of the yield curve and the onset of an actual recession. Utilities, energy and technology were the top gainers during the window.As you can see, oil does well and so does the financial and energy sectors. Energy and oil do well because inflation usually increases at the end of the cycle, meaning oil prices are going up along with the other commodities. Financials do well because the Fed fights inflation with higher rates. Higher rates mean higher net interest margins. The telecom sector under performs because rising bond yields mean investors don’t need to buy high yielding telecom stocks, which act as bond-like instruments, to get the returns they crave. Consumer discretionary under performs because input costs go up, squeezing margins. Inflation also hurts the consumer’s purchasing power.
Goldman Sachs chief global equity strategist Peter Oppenheimer believes that the reason for the continued rise in U.S. stocks is that as inflation levels rise, stocks are relatively more attractive, they are a real asset, and dividends will grow with inflation.
Jeffrey Kleintop, chief global investment strategist at Charles Schwab, believes that the stock market funds have not changed much. Typically, when the Fed is on a path to rapid rate hikes, funding conditions typically tighten, restricting lending and weighing on growth prospects, which can put downward pressure on stocks. But that's not happening now. Funding conditions are actually easing in major countries, including the United States. "
2. Expect Bearish - the current rally may be a "bear trap"
Strategists at Bank of America, including Gonzalo Asis and Riddhi Prasad were more cautious, arguing that the current rally in U.S. stocks could be a "bear trap." At present, the fundamentals are still weak, and the stock market has rebounded strongly despite the hawkish Fed and the inversion of US bonds, which is not sustainable.
They added that sharp rallies are typical of bear markets, where 10-day streaks of sharp gains are common historically. In 4 of the 11 bear markets since 1927, there have been 10 sessions of gains of more than 10%. At the moment, Fed policy is unlikely to support markets either; instead, the Fed is happy to see financial conditions tighten to help it contain inflation, which means risk assets have fallen.
Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, said in a note that the nascent rally in giant tech stocks could stall as the curve inverts. "At current valuations and earnings expectations, our estimates for these stocks are not optimistic, and Fed policy execution is more likely to exacerbate risks."
Michael Wilson, another analyst at Morgan Stanley, said that U.S. stocks have not fully reflected the adverse impact of the Fed's policy shift, high inflation and the Ukraine war on economic growth, and the current stock risk premium should be higher. They downgraded U.S. financial stocks to neutral from overweight.
3. See Divergence - Growth stocks will be under pressure, value stocks are preferred
Ankit Gheedia, head of strategy at BNP Paribas said, as yields rise, the fortunes of profitable and unprofitable companies will increasingly diverge. Therefore, investors should maintain their preference for global quality and profitable companies.
Joachim Klement, head of strategy, accounting and sustainability at Liberum Capital said, Higher borrowing costs could also put more pressure on growth stocks, which are valued for future growth expectations. Real yields should also start to rise, which will threaten growth stocks but support value stocks," said
Emmanuel Cau, head of strategy at Barclays saying value stocks would be "the best hedge against rising U.S. bond rates" as long as the macro backdrop remains supportive. Conversely, the recent rally in expensive tech stocks may lose steam due to stretched valuations.
Russ Mould, investment director at AJ Bell said, companies in highly indebted industries could also struggle if "interest rates do start to rise and the economy does start to slow."
Final Question For You:
How do you think the market tend to be?
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