Here's why the market is ignoring a tell-tale sign that a recession is coming

Published Mon, Jun 26 20232:18 PM EDTUpdated Mon, Jun 26 20236:51 PM EDT

For just shy of a year now, the bond market has been signaling that a recession is on the horizon. For the better part of the past six months, the stock market has been ignoring it. In early July 2022 , the 2-year Treasury yield surpassed that of the benchmark 10-year note , a phenomenon known as an inversion that has preceded each of the six recessions the U.S. has experienced going back to 1980. The time span between the initial inversion and recessions generally has been six to 12 months, putting the economy squarely in the sights of a seemingly inevitable downturn. Yet, stock market investors seem either not to notice or not to care, pushing the S & P 500 up about 13% year to date and nearly 11% from a year ago as gross domestic product has remained positive through the past three quarters. The apparently broken relationship may lie in what a peculiar time this has been for the financial and economic worlds since the Covid-19 pandemic broke out in March 2020. "The market's certainly not acting like it would if this 'Waiting for Godot' recession was right around the corner. It's a very odd thing," said Art Hogan, chief market strategist at B. Riley Wealth Management. "I would say it's much more about what started this conundrum, the combination of pandemic policy, pandemic reopening and hyperaggressive monetary policy. Throw that together, and it can throw off a lot of signaling." Indeed, a "this time is different" narrative could well apply to a situation the economy has never faced before: A unique global pandemic, met with the most aggressive fiscal and monetary response in history, all of which helped create the highest inflation level in more than 40 years, requiring a strong policy pivot in which the Federal Reserve is trying to engineer a soft landing that could include a shallow recession. For that reason, comparing short-term bond yields against the 10-year may not be as useful a measuring stick. A 71% recession probability? "There isn't anybody alive who can tell us what the playbook should look like after a pandemic," Hogan said. "What we have historically counted on for good signaling is [now] a weird confluence of events." For its part, the Fed concentrates more on the relationship between the three-month Treasury and the 10-year. That curve flipped in late October 2022, and just a few weeks ago, hit its widest gap ever. The New York Fed uses a model that computes the recession probability over the next 12 months using the relationship. As of the end of May, that was around 71% . The inversion level is little changed since then, so the recession probability likely is about the same. However, other indicators are not as clearly pointing to recession. Most notably, the labor market has been uncannily strong, with a 3.7% unemployment rate despite the Fed raising benchmark interest rates 5 percentage points since March 2022. The services part of the economy remains strong, and even housing numbers of late are turning around. The Fed, however, remains in inflation-fighting mode , raising short-term rates and possibly distorting the yield curve. Indeed, the central bank held off on a June hike but indicated two more increases are coming in 2023. "The Treasury yield curve tells an important but incomplete story about the US economy's risk of imminent recession," Nicholas Colas, co-founder of DataTrek Research, wrote in his market note overnight Sunday. "Monetary policy is purposefully tight at the moment because strong labor markets are still feeding inflationary pressures. That the 3m/10y and 2y/10y spreads are in very unusual territory is the Fed's way of addressing that problem." Colas noted that the Fed "has no other viable option now" as it seeks to pull down inflation, even if that means risking a recession. "Markets understand that but take comfort that the current labor market picture offsets some of that risk," he added. A recession unlike others There's also the "rolling recession" narrative to consider. Multiple sectors of the U.S. economy — autos, housing and manufacturing, to name three — have experienced what could qualify as contractions, and it's possible others could follow suit without tipping the headline GDP number negative. Wharton Business School Professor Jeremy Siegel sees the economy slowing further ahead. A key narrative from those looking for a recession is the lag effects that Fed policy will have. In fact, Siegel said the economy could slow so much that the Fed won't be able to deliver on the two potential rate hikes that officials penciled in following the policy meeting earlier in June. If that happens, markets are going to have to take notice. "It's hard to see upside catalysts for the market in the second half of this year," Siegel said Monday on CNBC's " Squawk Box ." "I think the bright side of a mild recession is that not only will we not get rate increases, but … we could get rate decreases by the end of the year." "I'm not talking about disaster," he added. "But when people are saying, 'what is on the upside?' I just don't see as many factors."