The Bond Market Is Doing Something Not Seen in Decades. It Could Signal Trouble in the Stock Market. | The Motley Fool

Many economists expected the United States to suffer a recession last year. Economists surveyed by The Wall Street Journal At the end of 2022 they placed the probabilities of a recession at 63%. The prevailing logic was that the Federal Reserve would raise interest rates too much, causing a substantial decline in spending that would turn into rising unemployment and an economic slowdown.

Instead, the economy remained rock solid in 2023 despite aggressive rate hikes and high inflation. In fact, economic growth accelerated last year, supported by strong (although slower) increases in consumer spending and business investment. The economy is currently projected to expand at an annualized rate of 2.9% in the first quarter of 2024, above the 10-year average of 2.5%.

In short, fears of a recession have dissipated. Many economists now believe the Federal Reserve will thread the needle and achieve a soft landing, meaning policymakers will control inflation without triggering a recession. Quote Morgan Stanley According to analysts, "the US economy is progressing well and almost all data validate the soft landing."

Yet the Treasury market—a recession forecasting tool with a near-perfect track record—continues to sound its most serious alarm in decades. Recessions have generally coincided with a substantial decline in the S&P 500. Here's what investors need to know.

Treasuries have predicted past recessions with near-perfect accuracy

US Treasury bond They are debt securities issued by the government. They pay a fixed interest rate until maturity, at which time the bondholder recovers the principal. The interest rate (or yield) is typically higher on long-term bonds than on short-term bonds. So he performance curve It normally slopes upward and to the right.

However, the yield curve inverts (starts high and falls as it rises) when long-term bonds pay less than short-term bonds. That can happen during periods of economic uncertainty. Some investors protect themselves against recession risk by purchasing long-term bonds to obtain guaranteed returns over a long period. Demand for those long-term bonds drives prices up and yields down.

For example, the 10-year Treasury bond currently pays less than the 3-month Treasury bond, meaning that part of the yield curve is inverted. What makes this noteworthy is the near-perfect accuracy with which those bonds have forecast past recessions. Specifically, a reversal between the 10-year and 3-month Treasury yields has preceded every recession since 1969, with only one false positive in the mid-1960s.

Treasuries are doing something investors haven't seen in decades

The chart below lists the start date of each yield curve inversion involving 10-year, 3-month Treasuries since the late 1960s, and the start date of the subsequent recession. The graph also shows how much time elapsed between the two events.

Data source: Federal Reserve Bank of New York, National Bureau of Economic Research. The chart above shows the correlation between US recessions and 10-year, 3-month Treasury yield curve inversions.

Yields on 10-year, 3-month Treasury bonds have inverted before every recession since 1969, and no more than 16 months have passed between the inversion and the subsequent recession. For context, the current inversion began 15 months ago, in November 2022, implying that the United States could fall into recession at the end of next month.

There is another point that investors should consider. The current yield curve inversion was most severe in May 2023, when the average yield spread (10-year Treasury yield minus 3-month Treasury yield) fell to -1.71%. The yield curve has not inverted this sharply since June 1981, when the average yield spread was -2.04%.

The curve has flattened since May 2023. The average yield spread was -1.3% in January 2024, but it still represents the lowest reading since August 1981, when the average yield spread was -1, 43%. In that context, Treasuries are doing something investors haven't seen in decades. In fact, a blog post from the Federal Reserve Bank of St. Louis says the implied "probability of recession would be unprecedented for a false positive."

Stocks often fall sharply during recessions, but tend to rebound sharply before recessions end.

He S&P 500 It is commonly considered a benchmark for the broader US stock market. Since its creation in 1957, the US economy has been hit by 10 recessions, during which the S&P 500 fell an average of 31%. In other words, if the economy falls into recession this year, history says the stock market would suffer a substantial decline.

This sounds quite alarming, but investors should avoid selling their shares. In fact, the most prudent course of action is to keep investing and keep buying. Good actions in reasonable valuations. I say this for three reasons. First, the bond market has been wrong in the past. The 10-year, 3-month Treasury yields reversed in January 1966, but that event was not immediately followed by a recession. The current inversion of the yield curve, despite its severity, could be another false positive.

Second, even if the economy were to suffer a recession, selling investors would not know when to buy again. The S&P 500 typically recovers about four or five months before a recession ends, and the index has historically returned a median of 30% between its bottom and the end of a recession, according to JPMorgan Chase. Investors trying time the market You will probably lose some of those achievements.

Third, despite the onset of several recessions since 1994, the S&P 500 returned 10.3% annually over the past three decades. Investors can assume similar returns over the next three decades even if the economy suffers a recession this year. But any attempt to time the market could backfire, setting investors up for poor performance in the long term.