Wall Street's Best Minds

Are Bonds Signaling a Peak in Stock Market?

The risks of a stock-crippling recession are rising but the odds of one are still just modest.

By Jeffrey Kleintop             
 

 
Here are the key points of this article.

• “Dr. Yield Curve” has accurately forecasted recessions and marked the start of bear markets in the past, making the yield curve significant for stock market investors.

• In the U.K., the heightened potential for a recession and bear market reflected in the yield curve is a risk investors in U.K. stocks should consider.

• Outside of the U.K., bond yields and stock prices are generally in agreement that the odds of a global recession are fairly modest.

Historically, when short-term interest rates rise above long term rates, bull markets for stocks have ended and bear markets have begun. In recent months, the difference between short-term and long-term interest rates, called the spread, has narrowed in many countries across the globe. When the spread between these rates turns negative, it is referred to as “inverting the yield curve.”
 
              
For instance, stock markets in the U.S. and around the world peaked in 2000 and 2007 when the spread between three-month and 10-year U.S. Treasury yields inverted by about 50 basis points (three-month Treasury yields were about one-half of one percentage point above the yield on the 10-year Treasury note).

[Editor’s Note: The three-month Treasury yield is still more than a percentage point below the 10-year yield, though the spread has narrowed in recent weeks, thanks to a drop in the yield on the longer-term bond.]

Why does an inverted yield curve signal a major peak for the stock market? Every recession in the United States—and accompanying global economic recession over the past 50 years—was preceded by an inverted yield curve.

The yield curve inversion usually takes place about 12 months before the start of the recession, but the lead time ranges from about five to 16 months. The peak in the stock market comes around the time of the yield curve inversion, ahead of the recession and accompanying downturn in corporate profits.

Examining yield curves from around the world, the prognosis on the likelihood of a global recession and bear market is favorable. Like a test showing a patient’s cholesterol is elevated but not yet in the danger zone, yield curves need to be monitored.

While the risk may be rising, the yield curves indicate that the risk of recession is currently modest—except for the United Kingdom—based on historical evidence, but history doesn’t guarantee future performance.

Last week’s loss by the Conservative party of its majority in the U.K. parliament is unlikely to make Brexit negotiations any easier. Yields may be reflecting the heightened challenges facing the U.K. In fact, the U.K. faces the highest probability of a recession in the coming year of any major country based on the slope of its yield curve and the history of U.K. recessions since 1970.
The spread between short and long-term yields in the U.K. has just slipped into the top of the 0-1% range where the historical probability of a recession in the next 12 months has been 62%, as you can see in the table below of yield spreads and recession probabilities.
 
 
Europe’s recession outlook per the yield curve post-U.K. vote

The impact of Brexit is likely to be primarily isolated to the U.K., with minor influences on global stocks. Brexit is likely to have a gradual impact on the U.K. economy due to the long and protracted nature of the negotiating process. The heightened potential for a recession and bear market reflected in the yield curve is a risk investors in U.K. stocks should consider.

Does the flattening yield curve in the bond market run contrary to the rising prices in the stock market? Are there differing diagnoses between bond and stock market investors on the prospects for the global economy? Not in our view. Slipping inflation expectations have been the main reason for the flatter yield curve and lower inflation has not always been a bad thing for stocks.

Outside of the U.K., bond yields and stock prices are generally in agreement that the odds of a global recession are fairly modest.

We can best see the close agreement between the bond and stock market when we look at high yield credit spreads and the stock market volatility. Both are at cycle lows, indicating little risk of a recession priced in the stock or bond market.

At first glance, a slumping yield curve paired with a rising stock market may seem at odds, but it’s clear to us that the message in the stock and bond market is the same: low risk of bear market and recession in the year ahead. However, stock pullbacks are common during bull markets and investors should maintain their long-term asset allocation to help insulate from short-term fluctuations.
Kleintop is chief global investment strategist with Charles Schwab & Co.


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