The bond market is sending a recession signal. Here's when investors should take it seriously

Published Tue, Mar 29 20226:54 AM EDTUpdated Tue, Mar 29 20223:17 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

The bond market is starting to send warnings about a recession , but stock strategists say it's not yet time to load up on recession-proof stocks. They also say regardless of whether the widely watched parts of the Treasury yield curve invert, it could be quite awhile before a recession arrives and there should be concurrent signals like a bigger slowdown in economic data before investors should worry. "Generally the yield curve signals usually well in advance of the recession. The 2-year to 10-year can sometimes invert two to three years before a recession," said Jeff Kleintop, chief global investment strategist at Charles Schwab. Kleintop said investors should stick with stocks that will do well in a recovery, like energy, industrials, financials and materials. The XLE, Energy Select Sector SPDR Fund reflects the S & P energy sector, and it has been a top performing major sector fund in March, up nearly 8%. Strategists say the bond market is sending a mixed message. Probably the most widely watched yield curve - the 2-year to 10-year has been flattening, and is close to inverting like other durations have already. On Tuesday, CNBC data showed the yield curve to be nearly perfectly flat, but it had briefly inverted on other bond data systems. The 5-year to 30-year inverted Monday for the first time since 2006. But the 3-month to 10-year section of the curve is doing the exact opposite, and it has been steepening, a signal for better growth. The spread on that part of the curve was 1.9 percentage points Tuesday, compared to the 5 basis points spread between the 2-year to 10-year yields. (1 basis point equals 0.01%.) (Click here to monitor that curve in real time.) "It's certainly a very mixed signal. You have 2s to 10s looking pretty bad, and you have the 3-month to 10-year looking the steepest it's been in five years...that's the one I pay most attention to," said Kleintop. "The yield curve isn't telling you there's going to be a recession any time soon." Kleintop said he's shifted away from higher valuation, longer duration stocks, like big tech and consumer discretionary. Strategists also say the sudden moves in the bond market this month reflect the Federal Reserve's more aggressive rate-hiking policy. They also say that if the central bank were to pause its rate hiking at some point or if the war in Ukraine were to end, inverted curves could reverse. Rates have been spiking. Last week alone, the 10-year yield went from 2.14% to a high of 2.50% Friday. What to watch Patrick Palfrey, Credit Suisse equity strategist, said he watches other factors in addition to the yield curve, and they are not signaling a recession. "The 2-year is pricing in all this Fed action right now...I would say look at the confluence of variables not just the yield curve," he said. He said ISM should be a positive signal this week. Analysts also expect a strong March employment report Friday to show 460,000 jobs were added, according to Dow Jones. "The market internals don't seem really concerned about a recession, as the bond market is or as investors currently fear," said Palfrey. "If you look at stocks that are most sensitive to the economy those that favor economic expansion are the ones that see superior performance." The Materials Select Sector SPDR Fund ETF, which represents the S & P material sector, is up 7% for March so far. The Consumer Staples Select Sector Fund, which would do better in a recession, was up just 1.1% in March. Financials which do better when the yield curve was steepening lagged the S & P 500's 5.8% gain for March so far. The XLF, Financial Select Sector SPDR Fund was up 2.3% for the month. If there were a recession coming, Palfrey said he would recommend stocks in "the more defensive groups - staples, utilities, healthcare, the telecom part of communications." Palfrey listed companies that should do well in a continued expansion. Many energy names were on the list, including Exxon Mobil, Devon Energy, and ConocoPhillips. Ralph Lauren , Eastman Chemical, Mosaic and CF Industries were also on his list. Financials that should do well in a growing economy include State Street, Lincoln National , Wells Fargo and Signature Bank. Stocks that have characteristics to weather a recession include Dollar General , Clorox, Kimberly-Clark, Campbell's Soup and American Water Works. Health care companies were also on the Credit Suisse list, including Thermo Fisher Scientific , Quest Diagnostics, Bristol-Myers Squibb and Abbott Labs. Signals crossed? Strategists say despite the possibility of an inversion between the 2-year and 10-year yields, it may not be the signal it once was. That's because the Federal Reserve is holding nearly $9 trillion in Treasury and other securities on its balance sheet, distorting the market action. The central bank purchased many of those securities through a quantitative easing program, which was established to add liquidity and help the economy during the pandemic. "By the Fed's own recognition, to have such a big QE program has depressed long-term rates," said Michael Schumacher, head of macro strategy at Wells Fargo. "We may get a recession anyway, but the signal from the curve is not that useful because of the balance sheet." In fact, Richard Bernstein Associates notes that if the Fed had never engaged in quantitative easing, the 10-year yield could be closer to 3.7%. Were it not for the central bank's bond-buying program, the yield curve for the 2-year and the 10-year would be more in the 150 to 200 basis point range, rather than the current slight positive spread, according to Michael Contopoulos, director of fixed income at Richard Bernstein Advisors. Even in the bond market, there is disagreement about the yield curve's message. "Nobody's stepping up, but the curve is staying inverted and the Fed is about to do a double tightening. That's a recipe for eventually impacting financial assets" and could also cause a recession, said George Goncalves, head of U.S. macro strategy at MUFG Securities. Besides its forecast for seven rate hikes this year, the Fed has said it would begin to shrink its balance sheet, which is considered policy tightening. Goncalves said there could be a recession, and he prefers to take cues from the 2-year to 10-year spread. He said it is a more valuable messenger while the 3-month to 10-year is better at warning once the recession is closer at hand or has already begun. "It's impossible for the 3-month/10-year to invert right now because the Fed only started hiking," he said, noting that the spread between the 2-year and 10-year would warn of a recession even earlier. The divergence is unusual, but Goncalves said it could be similar to the year 2000 when the 2-year to 10-year spread led long before the 3-month spread to the 10-year inverted. For awhile in 1999, they sent opposite signals, he said. The 2-year to 10-year inverted and sent the recession signal 422 days before the onset of the actual recession, while the 3-month to 10-year inverted 269 days before the recession. What's it mean for investors? A simple way to look at the importance of the yield curve is to think about what it means for a bank. The yield curve measures the spread between a bank's cost of money versus what it will make by lending it out or investing it. If banks can't make money, lending slows and so does economic activity. But some strategists say investors will ultimately take the bond market's behavior in stride and the inversions may not mean much. "Questions around recession risk for the US economy have increased. We continue to see that the inversion of the yield curve, on its own, is not sufficient to argue for heightened recession risk in the near term," wrote Morgan Stanley equity strategists. "We do not see the inverted yield curve as a causal factor driving recessions, and we see the risk of recession over the next 12 months as relatively contained." The Morgan Stanley strategists say the Treasury market's behavior is distorted by pension demand, quantitative easing and a flight to quality. "We think investors eventually will accept an inverted curve as a natural consequence of interest rate policy moving toward restrictive territory faster than balance sheet policy moves toward neutral territory," the Morgan Stanley strategists note.

A trader works on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., March 16, 2022.

Brendan McDermid | Reuters

The bond market is starting to send warnings about a recession, but stock strategists say it's not yet time to load up on recession-proof stocks.