The Bond Market Just Sounded Its Most Severe Alarm in 50 Years. It Could Signal a Big Move in the Stock Market in 2024

Recent signs of economic resilience have more and more investors giving credence to the "soft landing" narrative, a scenario in which the Federal Reserve successfully tames inflation without causing a recession. This growing conviction in this rather rare outcome helped propel the three major U.S. financial indexes higher in 2023.

Year to date, the blue-chip Dow Jones Industrial Average climbed 13% and set new all-time highs, the broad-based S&P 500 (^GSPC 1.02%) increased 23%, and the technology-heavy Nasdaq Composite soared 42%.

Yet, analysts at JPMorgan Chase and Deutsche Bank, among other financial institutions, still see a recession as a distinct possibility in the next 12-18 months. They are concerned that the impact of higher interest rates has yet to fully make its way through the economy, and consumers have propped up the economy so far with outsized spending that is depleting savings and causing many to take on added debt. Some analysts argue that an economic downturn is possible (or even probable) as those situations evolve.

A potential confirmation of the analysts' fears can be seen in the bond market, which is sounding its most severe recession alarm in decades. Read on to learn more.

The Treasury yield curve remains inverted

Treasury bonds are government-issued debt securities that pay interest based on their maturity date. The interest rate these bonds offer buyers is called the yield. When the yields on Treasuries with different maturity terms (from three months to 30 years) are plotted graphically, they form a line known as the yield curve.

That line generally starts low for short-term bonds and slopes upward for longer-term bonds under normal conditions. Bonds with longer maturities pay higher interest rates than bonds with shorter maturities in order to attract buyers. Investors want more compensation when locking money away for longer time periods.

During periods of economic duress, the Treasury yield curve can become inverted, where long-dated bonds offer less yield than short-dated bonds (something that's happened over the last two years). Aggressive interest rate hikes meant to curb inflation sent recession fears through Wall Street, and investors hedged against the risk of an economic downturn by moving to long-dated Treasuries.

Demand drives bond prices higher and yields lower. So demand for long-dated Treasuries has pushed yields lower (relative to short-dated Treasuries), causing the yield curve to start out high and get lower with longer-term bonds, thus inverting.

The yield-curve inversion is the bond market's most severe recession alarm in decades

The spread between the yields of the 10-year Treasury and 3-month Treasury is a closely watched economic indicator. That portion of the yield curve has inverted (the spread has turned negative) before all eight recessions since 1968, with only one false positive in the mid-1960s, according to the Federal Reserve Bank of New York.

That portion of the yield curve inverted in October 2022, and it remains inverted today. In the past, a recession has followed within two years, excluding the one false positive, meaning the yield curve signals a high probability that the U.S. slips into a recession by October 2024.

That alone is concerning, but the current situation is actually more significant. The spread between the 10-year and 3-month Treasuries reached -1.89% in June 2023, marking its steepest inversion in more than 50 years. The spread has since moderated, but the curve is still more steeply inverted today than it has been since 1980.

The chart below shows the spread between 10-year and 3-month Treasuries. The yield curve is inverted when the spread is negative, and the inversion becomes steeper as the trend line travels deeper into negative territory. The areas shaded gray indicate recessions.

10 Year-3 Month Treasury Yield Spread data by YCharts.

To summarize, the yield curve has consistently predicted recessions with remarkable accuracy during the last few decades. Yes, there was a false positive in the mid-1960s, but the spread was much less negative than it is today.

Indeed, the current inversion is the most severe recession warning the bond market has sounded in more than 50 years because the spread between the yields for the 10-year Treasury and the 3-month Treasury reached -1.89%. That has not happened in over five decades.

To that end, if the current inversion is not followed by a recession, it would be historically unprecedented, according to the Federal Reserve Bank of St. Louis.

So, here is the big question: What could a recession mean for the stock market?

A recession could sink the stock market, but there is a silver lining

The U.S. economy has suffered 10 recessions since the S&P 500 was created in 1957. For each recession, the peak decline in the S&P 500 is detailed in the chart below.

Source: Truist. Note: Percentages have been rounded to the whole number.

As shown above, history says the S&P 500 would fall about 31% if the economy slips into a recession. For context, the index is currently 2% below its record high, so the implied downside is about 29%.

That said, drawdowns have varied greatly in severity, simply because each recession is a product of unique circumstances. So any future economic downturn could entail a much smaller (or much bigger) decline in the S&P 500 than the historical average implies.

No forecasting tool is perfect. While historically uncommon, the Federal Reserve may indeed engineer a soft landing that brings inflation under control without eliciting a recession. But even if a recession were a guaranteed outcome, it would still be prudent to stay invested. Attempting to time the market -- selling before the recession starts and buying back in when it ends -- will almost certainly backfire.

The S&P 500 has historically rebounded four to five months before recessions end, generating a median return of 30% during that time period, according to analysts at JPMorgan Chase. Investors who sit on the sidelines until economic data proves the economy is in recovery will miss those gains, likely leading to long-term underperformance.

Here's the silver lining to any recession: The S&P 500 has returned an average of about 10% annually since its inception despite suffering economic downturns, bear markets, and corrections. There is no reason to expect a different outcome in the future. In that context, patient investors who buy and hold good stocks (or an S&P 500 index fund) will almost certainly be well rewarded over time whether or not a recession materializes in 2024.