Dec 9, 2018

The market rally that could signal a coming recession

Data: Factset; Chart: Lazaro Gamio/Axios

You might have missed the huge market rally last week, what with all the political news and stock market noise. The price on the benchmark 10-year Treasury bond rose from 100.22 on Monday morning to 102.12 at the close on Friday.

Why it matters: That's a massive move in the world of bond investors. It brought the yield on the bond from 3.04% all the way down to 2.85%. (Yields go down when prices go up.) Bonds vastly outperformed the stock market, which fell by 5.6% from Monday's open to Friday's close.

What's happening: The yield on 10-year notes is falling even as the market expects one more rate hike from the Fed this month. In market jargon, the yield curve is flattening.

  • When long-term yields are lower than short-term yields, that's an "inversion," and like night follows day, whenever you hear the phrase "inverted yield curve," the word "recession" is sure to follow.

The curve has not yet inverted. Small bits of it have inverted, but the yield on the 10-year note is still a tiny bit higher than the yield on 1-year notes, and that's the main indicator that economists look at when they ask whether a recession is coming. Right now we're about 15 basis points away from an inverted yield curve.

  • If the yield curve does invert, there's no reason to panic, certainly not when it comes to the stock market. LPL Financial Senior Market Strategist Ryan Detrick notes that the S&P 500 didn’t peak for more than 19 months, on average, after the yield curve inverted. On average, it gained more than 22% before reaching its high point.

If an inverted yield curve isn't bad for stocks, it's not bad for the economy either. When long-term rates are lower than short-term rates, that encourages long-term investment, which is a good thing. And while recessions do always arrive eventually, the time between the yield curve first inverting and the recession arriving can be as long as 765 days, as the chart above shows.

  • Yield curve inverted in March 1973; recession began 297 days later.
  • Yield curve inverted in August 1978; recession began 560 days later.
  • Yield curve inverted in September 1980; recession began 350 days later.
  • Yield curve inverted in February 1989; recession began 564 days later.
  • Yield curve inverted in August 2000; recession began 272 days later.
  • Yield curve inverted in December 2005; recession began 765 days later.

Our thought bubble: The yield curve is not, yet, flashing a recession sign. A recession is not a bear market, and neither does it mean a financial crisis. There will be another recession at some point. But it might be very mild.

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