Some investors may be freaked out over the recession signal being sent by bond market rates, but if history is a guide, there is still time to capture more gains in the stock market.
The so-called 'yield curve inversion' where the yield, or interest rate, on shorter term Treasury instruments — in this case the 3-month — rises above a longer-dated Treasury yield, or that of the 10-year note, is a classic recession indicator that is often correct. As analysts say, there haven't been recessions without a curve inversion but on the other hand, not all curve inversions lead to recession.
But Canaccord Genuity and some other firms point out, the stock market tends to react later, and the recession could also come two years or more into the future. "An inverted yield curve is not 'good,' but the 'bad' works with a significant lag," Canaccord analysts wrote.
On Friday, the combination of the Fed's dovish forecast after its meeting Wednesday and weak German manufacturing data combined to drive the 10-year yield sharply lower to 2.41 percent. The 3-month yield was at about 2.45 percent, but not falling as much. Rates move opposite price, so bad news on the economy results in lower yields. The curve remained inverted Monday, with the 3-month at 2.45 percent, above the 10-year yield of 2.42 percent.
Canaccord strategist Tony Dwyer said he believes investors should wait for trouble to bubble up in credit markets before taking on a sustainable defensive stock market position. Dwyer said the median gain in the S&P 500 from the initial inversion to cycle peak is 21 percent, with recession occurring a median 19 months after the initial inversion. In the last three most similar cycles, the S&P rose 34 percent and the recession was 25 months later.
"You can see the median move to peak is 21 percent. It's 34 percent over the course of the last three cycles. Why would you get defensive now with the data showing what it's showing?" said Dwyer. Dwyer said over time, the moves between he 3-month and 10-year, and the more widely watched 2-year to 10-year spread are similar though the 2-year to 10-year spread is not yet inverted.
Source: Bespoke Investment Group
The low-yield on the 10-year is eerily close to the fed funds rate, at about 2.40 and that has some market pros concerned, but Wedbush's Steve Massocca said the bond market phenomena could actually be different this time and be the result of extraordinary easing after the financial crisis that took many sovereign bond yields to negative levels.
"I believe there continues to be overwhelming demand for US Government debt," he wrote in a note. "By far the US has the best or highest rates. This is versus many countries having zero or even negative rates, there is currently over $11 Trillion dollars of outstanding sovereign debt with negative yields! Regardless of economic perceptions be they good or in the case of Friday bad, the value inherent in US Government debt is creating exceptional demand."
Massocca said the market move is being exacerbated by short positions hoping to benefit from a "normalization" of interest rates. "The German 10 year yield moved to a negative number on Friday and my bet is that was driven by short covering," he added.