Zinger Key Points
- The yield curve un-inverted, a rare signal historically linked to market crashes like 1929, 2000, and 2008.
- Rising bond yields challenge stocks by increasing borrowing costs, compressing valuations, and competing for investor dollars.
A critical bond market indicator is flashing red, reigniting fears of a potential stock market collapse. The yield differential between the 10-year U.S. Treasury bond and three-month Treasury bills, often dubbed as one of the most reliable recession predictor, recently switched from negative to positive territory.
Historically, this rare shift has been a harbinger of sharp market declines and economic downturns.
"The most widely followed yield curve has just un-inverted. This is quite a rare signal that’s almost perfectly predicted every recession in modern history," Bravos Research wrote in a Monday newsletter to subscribers.
A Track Record Too Accurate to Ignore
The yield curve is often viewed as one of the most reliable tools for spotting an impending recession. In particular, the 10-year minus three-month yield curve has been a reliable predictor for some of the worst financial disasters in history.
“These un-inversions have often occurred right before major bear markets, like 1929's 80% crash, the dot-com bubble's 50% drop, and 2008's 60% collapse,” Bravos Research wrote.
Furthermore, the yield gap between the 10-year Treasury bond and the three-month bill turned positive In October 2019 after being negative, foreshadowing the March 2020 market selloff just a few months later.
Yet it's not an infallible crystal ball. In 1979, for instance, stocks continued climbing even as the economy entered a recession.
Could today's market defy history, or are we looking at yet another warning that's about to come true?
Why Does The 10-Year Minus 3-Month Yield Curve Matter?
The 10-year minus three-month yield curve is often considered the gold standard among yield curves because it reflects two critical forces in the economy.
The three-month yield is influenced by the Federal Reserve's interest rate decisions, making it a clear signal of short-term monetary policy. The 10-year yield, on the other hand, is shaped by private investors and is often considered a proxy for the “neutral rate,” or the ideal interest rate for stable economic growth.
The curve inverts when short-term rates exceed long-term rates, a dynamic that occurs when the Federal Reserve's tightening policies outweigh market expectations for long-term growth.
Historically, these inversions are seen as warning signs of economic slowdown. However, when the curve un-inverts—flipping back to a positive slope—it typically signals that the Fed is preparing to cut rates to counter slowing growth.
This is usually when the economy is on the verge of a recession.
Why Is This Time Different?
While the yield curve's un-inversion has signaled the onset of recessions in the past, today's situation is unusual because the 10-year yield is not declining. Instead, it has been rising steadily. This breaks from the historical pattern.
During previous recessions, the 10-year yield dropped sharply as economic growth slowed. Today, bond traders seem to be pricing in economic resilience rather than an imminent slowdown.
“Today's un-inversion stands out because unlike the past instances, the 10-year yield has actually been rising recently today,” the Bravos Research team wrote, adding that “bond traders are not worried about imminent recession.”
Are Stocks In Trouble?
Rising bond yields often create challenges for equities, particularly for growth-oriented sectors.
Higher yields increase borrowing costs for companies, compress valuations and compete with stocks for investor dollars. Historically, such an environment has led to short-term volatility in the stock market.
The unemployment rate also adds a layer of caution. When overlaying the yield curve with unemployment data, Bravos Research noted, "If the yield curve continues to steepen, the unemployment rate could move higher, triggering a potential recession."
Bravos Research advises investors to remain wary of volatility for the near term while capitalizing on opportunities for the long term. “With the recession timeline extended, it seems like any market volatility is a potential buying opportunity.”
The S&P 500 index – as tracked by the SPDR S&P 500 ETF Trust SPY – has rallied by more than 50% over the last two years.
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Image from Bravos Research webpage
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