If you want to know what’s in store for stocks, pay attention to the bond market. This is something we tell our customers over and over again. Interest rates have an outsized effect on equity valuations. The shape of the Treasury yield curve contains all kinds of information about economic expectations. Credit risk spreads indicate what investors require to take out loans with a higher risk of default. Indeed, the bond market is meant to be the sober and thoughtful repository of market information, while the stock market’s daily mood swings reflect a collection of fickle emotions and insane group thoughts.
Dangerous curves ahead
That’s how it’s supposed to work. But the bond market today seems to be sending mixed messages. The Treasury yield curve inverted slightly in the so-called “belly” – between 5-year and 10-year Treasury bills. It’s so close to doing the same in the broader scope between the 2-year and 10-year timeframes. A 2-10 reversal scares investors due to its historic foreknowledge as a predictor of an impending recession. The graph below shows this record for the four recessions we have experienced since 1990.
A word about this table is in order, however. The 2-10 curve reversed very briefly in the fall of 2019, and then we had a recession in 2020. But that recession had absolutely nothing to do with the economy of September 2019 or, for that matter, the economy of September 2019. February 2020 economy. The recession happened because we shut down the economy when the pandemic hit. Absent a pandemic, and given all the other data we have about the economy at the time, it seems highly unlikely that we entered a recession at that time. So the 2019 2-10 reversal would seem to need an asterisk, at best.
Nevertheless, the fact that the short end of the curve is rising while the longer maturities remain unchanged (or do not rise by the same magnitude) suggests that fears of an economic reversal are stronger than they were. few months ago. Last week, after the meeting of the Federal Open Market Committee, Fed Chairman Powell argued that a series of methodical increases in the federal funds rate would gradually reduce inflation while the unemployment rate would fall to 3.5% and would stay there, as GDP growth continues. at a rate slightly higher than the trend. The bond market, at least according to the flat yield curve, doesn’t seem to entirely agree with this assessment and thinks a harder landing may be in store.
Credit risk complacency
Then we come to another important bond market dynamic: credit risk spreads between benchmark Treasuries and corporate bonds. In particular, the spread between 10-year Treasuries and the riskiest companies (Moody’s Baa) is around 2% today. That’s tighter than the three-year average of around 2.3%, and comfortably within the normal spread range during periods of economic growth, as seen in the chart below.
In other words, credit risk spreads don’t tell us that we should prepare for an impending recession. We would expect these spreads to widen before a downturn, as the risk of default would be higher. Remember that the only way a bondholder will lose money, assuming they hold the bond to maturity, is if the company defaults. Otherwise, it is a predictable stream of cash flow from timely interest and principal payments.
So which of these posts is right? For much of the year, we have been publicly stating that the likelihood of a recession over the next twelve months is quite low, given current levels of consumer demand and a tight labor market. So, in that sense, we more or less agree with the view expressed by Powell at the FOMC press conference last week. That being said, we don’t completely agree with the idea that inflation can come down from its current levels to the Fed’s 2% target without more pain than the soft landing in the vision of the Powell’s world. We’ll talk more in future comments about some of the things happening in the world that may be beyond the Fed’s ability to resolve with a mild, measured series of fed funds rate hikes. In the meantime, we think there might be some truth in these two signals from the bond market, the yield curve and risk spreads.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.