The Signals from the Bond and Stock Markets

For almost a year now, the bond market has been indicating that a recession could be coming. However, the stock market has been largely ignoring these signals. In July 2022, the 2-year Treasury yield exceeded the benchmark 10-year note, a phenomenon known as an inversion that has historically preceded recessions. Typically, a recession occurs within six to twelve months after the initial inversion. Despite this, the stock market has remained strong, with the S&P 500 up 13% year to date.

A Unique Economic Landscape

The disconnect between the bond and stock markets may be attributed to the exceptional circumstances resulting from the Covid pandemic. Unprecedented fiscal and monetary responses have created the highest level of inflation in over 40 years. The Federal Reserve is now attempting to engineer a soft landing while dealing with the possibility of a shallow recession. Consequently, using short-term bond yields to predict a recession may not be as reliable.

The Federal Reserve’s Perspective

The Federal Reserve focuses on the relationship between the three-month Treasury and the 10-year Treasury. This curve flipped in late October 2022 and recently hit its widest gap ever. According to the New York Fed’s model, the recession probability over the next 12 months is around 71%. However, other indicators, such as the strong labor market, suggest a different outcome. The Fed remains committed to fighting inflation and raising short-term rates, potentially distorting the yield curve.

The “Rolling Recession” Narrative

Some economists propose a “rolling recession” narrative, where specific sectors of the economy experience contractions without significantly impacting the headline GDP number. Sectors like autos, housing, and manufacturing have already been affected, and more could follow suit. Wharton Business School Professor Jeremy Siegel believes the economy will slow further, which could affect the Fed’s ability to implement future rate hikes.

Predicting the Market’s Path

Market analyst Nicholas Colas points out that the Treasury yield curve provides incomplete information about the risk of an imminent recession. The Fed’s tight monetary policy reflects concerns about inflation stemming from strong labor markets. Although the risk of recession exists, the current labor market picture provides some comfort to investors. On the other hand, Professor Siegel does not foresee many factors that could drive market growth in the second half of the year, suggesting a potential need for rate decreases.

While the future path of the economy remains uncertain, it’s important to consider the unique circumstances surrounding the Covid pandemic and the measures taken to mitigate its impact.