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And below, read on for Clint Brewer’s latest market update…
While the stock market has made a lot of headlines this year, the bond market has made downright historic and unprecedented price moves.
When bond yields rise, their prices fall. The current jump in the 10-year Treasury yield has sent its price plunging down over 19% this year. That ranks as the worst year ever on record.
However, it’s not just the longer maturities. In fact, short-term bond prices have been falling as well, meaning their yields are skyrocketing.
As the Federal Reserve jacks up interest rates on short-term bonds at an even quicker pace than long-term bonds, this has caused something called an inverted yield curve…
The Recession Indicator with a Perfect Record
Historically, an inverted yield curve is a solid predictor of recessions.
The yield curve simply measures the difference between the rate on a short- versus long-term bond. It becomes inverted when the interest rate on the shorter maturity rises above the longer one.
And it works as a recession signal due to one key variable: the Fed.
Typically, when short-term rates rise above longer ones, it’s due to the Fed’s aggressiveness in pushing up interest rates on the short-end. We’ve already seen three consecutive 0.75% rate hikes this year, with a fourth expected next week.
The Fed is doing this to make it more expensive for individuals and businesses to borrow. Higher borrowing costs slows lending activity, which slows the economy. And that’s how the Fed hopes to tame inflation.
But an inverted yield curve warns the Fed it’s starting to enter the danger zone. And one curve in particular could stop the Fed in its tracks and turn the stock market around. In fact, it has preceded every recession in the last 60 years…
I’m talking about the spread between the 3-month and 10-year Treasury yield.
I believe Fed members closely follow this curve when making policy decisions. The central bank even wrote a paper about the predictive ability of this metric.
As Fed researchers stated, “it is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six quarters ahead.”
And here’s what it’s signaling now…
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Pause the Panic
On the chart below, you can see how this curve inverted below zero (black line) just last week for the first time since heading into the 2020 recession. The last recession periods are shaded in grey…
This is a clear signal rate increases are starting to have a major impact on our economic outlook.
But that’s where the good news for investors comes into play… By triggering this recession signal, the Fed may finally take a pause and assess their actions.
The rapid pace of increases has been a major catalyst for falling stock prices, so a temporary halt can act like a pressure relief valve for stock prices.
Now, don’t mistake a “pause” for an outright “pivot” to easier monetary policy. As I talked about in my last commentary, I still believe we’re in a bear market.
But at the very least, a tactical rally in the stock market could be developing.
Analyst, Market Minute
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When do you think the Fed will consider pausing rate hikes?
Let us know your thoughts – and any questions you have – at [email protected].