The Bond Market Is Sounding This Alarm for the First Time in Decades: Here’s What It Could Mean for the Stock Market.

The U.S. economy expanded at an annualized 4.9% rate in the third quarter, growing more than twice as fast as the long-term average. That reading is somewhat surprising in context. Many economists had warned of a recession this year, citing the nearly unprecedented pace at which the Federal Reserve has raised interest rates to curb inflation.

Those warnings seem almost laughable in light of the latest data, but that data may have captured the calm before the storm. Robust economic growth in the third quarter was a product of resilient consumer spending, but JPMorgan Chase says consumers are depleting savings and taking on debt to fund purchases. That is not sustainable, especially since student loan payments have restarted.

Meanwhile, business spending actually stalled during Q3, presumably because high interest rates have made financing options much less attractive. Some experts expect that trend to intensify in the coming quarters, and that might be the first domino to fall, setting in motion a series of events that ultimately leads to an economic downturn.

Indeed, the bond market is sounding its loudest alarm in decades. Earlier this year, the U.S. Treasury yield curve suffered its steepest inversion since 1981, and yield curve inversions have forecast recessions with near-perfect accuracy since 1955.

Image source: Getty Images.

The U.S. Treasury yield curve suffered its steepest inversion since 1981

U.S. Treasury bonds are debt securities that pay interest at varying rates based on their maturity dates. Normally, the interest rate (or yield) increases as the maturity timeline lengthens. That happens because investors demand greater compensation when locking money away for longer time periods. For instance, the 10-year Treasury note typically pays more than the two-year Treasury note.

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However, that portion of the yield curve is currently inverted, meaning the 10-year Treasury is paying less than the two-year Treasury right now. The same inversion has preceded every recession since 1955, with only one false positive, according to the Federal Reserve Bank of San Francisco. The only caveat is timing. Following an inversion, a recession has materialized anywhere from 6 to 24 months later.

What makes the current situation special (or alarming) is the severity of the inversion. As shown in the chart below, the spread between the 10-year and two-year Treasuries (the difference between the yields) recently reached a level not seen since 1981. The curve has since flattened to some degree, meaning the inversion has become less pronounced. But the spread is still more negative today than it has been since 2000.

10-2 Year Treasury Yield Spread data by YCharts. Note: The gray areas denote recessions.

Another widely following forecasting tool is also sounding a recession alarm. The Conference Board Leading Economic Index (LEI) tracks 10 indicators that cover a range of economic activity, from manufacturing and employment data to consumer expectations and stock market returns. The LEI has fallen for 19 consecutive months as of October 2023.

Senior Manager Justyna Zabinska-La Monica provided the following context: “The Conference Board expects elevated inflation, high interest rates, and contracting consumer spending — due to depleting pandemic saving and mandatory student loan repayments — to tip the U.S. economy into a very short recession.”

What would that mean for the stock market?

The S&P 500 typically falls about 32% during recessions

The S&P 500 (^GSPC 0.06%) has soared 18% year to date on signs of economic resilience and enthusiasm surrounding artificial intelligence stocks. But history says the index would reverse course and decline sharply if the economy suffers a recession.

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Indeed, the S&P 500 plunged by an average of 32% during the 10 recessions that have taken place since 1955, according to Bloomberg. For context, the index is currently down 5% from its record high, so it would decline another 27% if the economy slips into an average recession. Many stocks would undoubtedly suffer deep losses in that scenario.

The S&P 500 typically rebounds about 30% before recessions end

Investors may be tempted to sell their stocks until the (potential) storm passes, but they should bear in mind the familiar platitude: Past performance is never a guarantee of future results. Yes, the inverted yield curve has reliably forecast every recession since 1955, but it did show a false positive in the mid-1960s, and it might be showing another false positive right now.

Even if the current inversion is a real recession warning, investors should still sit tight because predicting a stock market rebound is impossible. The S&P 500 has historically hit bottom about four months before the end of a recession, and it returned about 30% during the interim, according to JPMorgan.

That statement has huge implications: Even if someone could predict the onset of a recession, selling out of the stock market would be foolish. The S&P 500 would likely move much higher before economic data verified the end of the recession, so they would almost certainly miss out on big gains by attempting to time the market.

Here’s the bottom line: Investors should hope for the best, but plan for the worst. In this case, that means steeling themselves against knee-jerk reactions and emotional decisions. The S&P 500 has eventually rallied to new highs following every recession, so the best course of action is to stay invested.

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