Stock Investors Brush Off Inverted Yield Curve

Despite the continued inversion of the yield curve, which signals a looming recession, stock investors remain optimistic. For the past year, interest rates on U.S. Treasury bonds with varying maturities have shown a downward slope, indicating that yields on long-term debt are lower than those on short-term securities. This is known as an inversion of the yield curve, which typically means that investors expect higher economic risk or interest rates in the near future and therefore require more compensation.

Historically, an inverted yield curve has usually been a sign of an impending US recession: every recession since the 1950s has been preceded by an inverted yield curve. The gap between the yield on 2-year and 10-year Treasury notes is the largest since the Silicon Valley Bank failed in early March, and the yield on 6-month Treasury bills is the highest on the curve at 5.45% compared to 3.71% for the 10-year note. This inversion magnitude was last seen in the 1970s and 1980s, another period marked by high inflation and rising interest rates that saw several recessions.

Although Dow Jones Market Data shows that inversions can precede recessions by anywhere from seven months to two years, stock investors are still optimistic about the future. This contrasts with a recession probability model developed by the New York Federal Reserve that predicts a 71% probability of a recession in the U.S. over the next 12 months using a 3-month/10-year spread.

The Impending Recession and Stock Market Resilience

The inverted yield curve is often considered a warning sign of an imminent recession. However, the stock market in 2023 has been resilient despite the signal. Investors seem to anticipate a shallow recession later this year or in 2024. The most severe effects of the regional banking mini-crisis are likely over and there aren’t any apparent signs of an asset bubble about to burst or an impending credit crunch.

Although the U.S. economy may experience a few quarters of declining GDP, this downturn is projected to be less severe than those resulting from recent recessions caused by Covid-19 or the 2008-2009 financial crisis. This theory will keep corporate earnings up. In addition, investors are reportedly confident that inflation will continue to decline towards the Fed’s 2% target during the coming quarters.

According to Nicholas Colas of DataTrek Research, “The Treasury yield curve tells an important but incomplete story about the U.S. economy’s risk of imminent recession.” He believes that strong labor markets are still causing inflationary pressure, therefore monetary policy is purposefully stringent at the moment. The Fed is solving this problem by keeping the 3m/10y and 2y/10y spreads in unusual territory.

Colas argues that the strength in the labor market that is driving some of today’s inflation could reduce the impact of a slowing economy, resulting in a relatively brief, mild recession. This gives investors enough confidence to concentrate on the recovery ahead since stocks are forward-looking, and they ignore the yield curve’s warning.

Wolfe Research’s Chris Senyek agrees, stating that “in our view, equity market investors are largely ‘looking through’ this classic recession signal.” As of Tuesday, the S&P 500 was up 13% for the year thus far.

The Yield Curve and Its Impact on Markets

As the yield curve remains inverted, investors are wondering how long this trend will continue. Despite the Fed’s announcement of a half percentage point increase in interest rates, short-term Treasury yields could still rise further. However, there are several factors weighing down long-term yields.

According to Steven Ricchiuto, U.S. Chief Economist at Mizuho Securities USA, excess liquidity in markets and the threat of global deflation have contributed to long-term rates remaining low. Furthermore, China’s economic growth has continually fallen short of expectations and COVID-19 has not reversed the global economy’s supply of tradable goods.

The persistent low long-term rates have also hindered the Fed’s rate hikes, supporting a “higher for longer” approach. Typically, an inverted yield curve becomes uninverted once a recession hits as markets anticipate the Fed cutting its interest rate to revive the economy. However, if inflation is still high and the recession is shallow, the Fed may be slow to act.

Ricchiuto predicts that the yield curve will remain inverted throughout the recession. This could pose a challenge to banks’ core business models, which rely on borrowing short to lend long. Nonetheless, stock investors remain optimistic and are already focusing on future opportunities.

In conclusion, the current yield curve trend and its impact on markets are a topic of concern for investors worldwide.

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