Bond recession indicator hits most extreme level in 40 years, raising questions about stock rebound

Published Fri, Nov 18 202210:32 AM EST

A closely watched part of the bond market for its recession prediction abilities reached its most extreme levels since 1982, casting doubt over the stock market rebound since mid-October. The spread between the 2-year Treasury yield and the 10-year rate reached 68 basis points on Thursday, the widest in four decades on a closing basis (One basis point equals 0.01%). The so-call yield curve shows investors what they can expect to earn from different maturities. Longer-duration bonds typically yield more than short-term ones given that investors take on more risk to hold them. A flip in that relationship, or inversion of the curve, is typically viewed as a signal that a recession is on the horizon. The yield curve inverted before the 2020, 2009, and 2001 recessions but often with large lag times. But even with this flashing warn sign, stocks have staged a solid comeback as a better-than-feared CPI print hinted that inflation may be easing and ignited hopes that the Federal Reserve may soon slow its tightening pace. Meanwhile, the S & P 500 is up roughly 2% this month and just below the 4,000 level after posting its best weekly stretch since June last week . "My contention would be that ultimately the yield curve is going to prove correct," said Gregory Faranello of AmeriVet Securities, saying it takes time for equities to catch up with what's happening with the yield curve. "The economy is going to slow more significantly as we head into 2023, and, I think at some point risk assets will grasp that notion and probably head back down lower." Strategists also closely watch the relationship between the 10-year and 3-month Treasury notes, which hit a deep inversion this week and has an "excellent track record" of predicting a recession, said LPL Financial's Quincy Krosby. To be sure, equities can rally even with an inverted yield curve, and they've done that in the past. Strategas' Chris Verrone pointed out in a note to clients Thursday that the 1979-to-1980 inversion saw two 20% rallies in the S & P, while the 1969 inversion saw a handful of 10% bounces when the 10-year and 3-month spread was at a deep inversion. 'Disorienting' "As we noted earlier in the week, the juxtaposition between the equity market's post-CPI momentum spark over the last week vs. the shape of the yield curve message is disorienting," Verrone wrote this week. Given that the market is still likely in bear territory, these rallies aren't out of the question, Krosby said. Investors participating for the long term, however, should proceed with caution, she said. Those looking to get into this market should seek out companies with strong cash flows that can weather a recession, pay good dividends, and trade at attractive valuations, Krosby added. She pointed to energy and industrials, in particular defense, as some areas of the market that offer these qualities. "Be aware of the fact that as long as the bear is alive, at some point the bear gets everything," she said. "It's very rare in a bear market that the bear doesn't even affect those companies that we were in, we believe will protect us. At some point, the bear will get them too." — CNBC's Michael Bloom and Gabriel Cortes contributed reporting