A reliable recession predictor flashed in the US bond market last week: the most closely watched part of the Treasury yield curve inverted. At first, stocks shuddered. Then they shrugged it off.
The S&P 500, Dow and Nasdaq rose Tuesday as investors decided it was too soon to worry about a pullback — even as bond yields remain depressed.
“We’ve still got some run time,” said Brad McMillan, chief investment officer at Commonwealth Financial Network. The equities rally, he added, “can persist for a while.”
Stocks and bond yields have been moving in different directions for months, sending conflicting signals to investors watching for warning signs about slowing global growth. The S&P 500 has jumped 19% since its December lows, while the yield on the benchmark 10-year Treasury note has fallen off. Investors typically view falling bond yields as a sign of economic pessimism, because it points to higher demand for a safe haven asset.
Investors were forced to reckon with that divergence last Friday, when the yield on 3-month Treasuries rose above the rate on 10-year Treasuries for the first time since 2007. The so-called yield curve inversion, in which short-term rates jump above long-term rates, has preceded each of the last seven recessions, according to the Federal Reserve Bank of Cleveland.
Stocks plunged 460 points to close out the week after the inversion on Friday. But investors calmed down. They have an eye toward first quarter earnings, and appear to believe a sell-off would be premature.
Their primary rationale is that a partial yield curve inversion — and it has since narrowed — doesn’t mean a recession will strike immediately.
When the curve inverts, the average time to the next recession is 27 months, according to a Bank of America Merrill Lynch Global Research report this week. The range has varied between nine and 66 months.
Analysts generally say the inversion can indicate a recession in about a year. However, it’s not a given, and wait times remain imprecise.
“In addition to there having been ‘false positives,’ an inversion doesn’t help define either the length of runway between the inversion and the subsequent recession; or the severity of the recession,” Liz Ann Sonders, chief investment strategist at Charles Schwab, said in a note Monday.
There’s also a persistent calm regarding US economic fundamentals. The US economy has added jobs for the last 101 months. The Conference Board said Tuesday that its Consumer Confidence Index declined in March, but consumers still expect the economy to continue expanding in the near term.
“The reality is, the conditions continue to be favorable,” McMillan said.
That could give stocks space to continue their run. Michael Darda, chief economist and market strategist at MKM Partners, said in a note this week that stock markets usually, but not always, peak after a yield curve inversion.
Additional volatility isn’t off the table entirely.
Peter Boockvar, chief investment officer at Bleakley Advisory Group, said he expects Friday’s bond market omen to weigh on investors.
“The bond market is saying one thing [and] the equity market is saying another,” he said. “Maybe the bond market’s on to something that we need to pay attention to.”
Much hinges on corporate earnings results from the first three months of the year. They’ll begin to post next month.
Investors seem optimistic about earnings, even though an above-average number of companies are revising their outlooks lower.
Of S&P 500 companies that have issued earnings guidance, 73% have downgraded expected earnings per share, according to FactSet.
McMillan said that’s okay — so long as companies end up under-promising and over-delivering.
“It’s about expectations,” he said. “And companies have been actively managing their expectations down.”