The Bond Market Is Sounding Its Most Severe Alarm in Decades, and It Could Mean Trouble for the Stock Market

The U.S. economy expanded 2.5% last year, an acceleration from 1.9% in 2022 and above the 10-year average of 2.3%. That economic momentum sent the benchmark S&P 500 (^GSPC +0.83%) soaring 24% in 2023, its third-best annual performance of the past decade.

Not many people saw that coming. After inflation hit a four-decade high in 2022, the Federal Reserve compensated by raising interest rates at their fastest pace in decades. Many economists initially thought that would lead to a recession in 2023. But that recession never happened, and the consensus view now calls for a soft landing, a scenario in which inflation normalizes without an economic downturn.

Indeed, economists surveyed by The Wall Street Journal in April 2024 estimated the odds of a U.S. recession at 29%, a significant decline from 61% in April 2023. However, a popular bond market indicator with a near-perfect track record is still sounding an alarm: The 10-year and 3-month Treasury yields have been inverted since November 2022, and that could mean trouble for the stock market.

Here's what investors should know.

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The Treasury yield curve is flashing a recession warning

Treasury bonds are debt securities issued by the federal government. They pay a fixed interest rate until maturity, which ranges from one month to 30 years, at which point the bond holder recoups the principal investment.

The interest rate (or yield) on debt securities typically increases as the maturity lengthens, meaning a 10-year Treasury normally pays more than a 3-month Treasury. As such, the yield curve -- a graphical representation of the interest rates on Treasuries of different maturities -- normally slopes upward and to the right. But the yield curve becomes inverted when a long-dated Treasury pays less than a short-dated Treasury.

Yield curve inversions can happen when investors are worried about a recession. To elaborate, some investors prefer to own long-dated Treasuries (which offer risk-free returns) rather than stocks or other risky assets during periods of economic uncertainty. Bond prices and yields move in opposite directions. So, with enough buying pressure, long-dated Treasuries can wind up paying less than short-dated Treasuries, creating a yield curve inversion.

The term spread between the 10-year and 3-month Treasuries -- meaning the 10-year Treasury rate minus the 3-month Treasury rate -- is of particular interest to investors because it has predicted past recessions with near-perfect accuracy. In fact, the term spread has turned negative (signaling a yield curve inversion) prior to every recession since 1968.

This chart shows the onset of each yield curve inversion and subsequent recession since 1968.

Data source: National Bureau of Economic Research, Federal Reserve Bank of New York. Note: The yield curve inversion dates correspond the first month in which the average term spread was negative.

As shown in the table, the United States economy has suffered eight recession since 1968. The Treasury yield curve inverted before each one, and the inversion started no more than 16 months ahead of the recession. That means the current situation is somewhat unique for two reasons.

First, the 10-year and 3-month Treasury yields have been inverted for 17 months (and counting) without a recession, something that has not happened in at least 56 years. Additionally, the average term spread in March 2024 was negative 1.17%, the lowest reading (excluding the current inversion) since negative 1.43% in August 1981. That means the yield curve is more steeply inverted than it has been in four decades.

In short, the bond market is not merely sounding an alarm -- it is sounding the most severe recession alarm since 1981.

The stock market has fared poorly during past recessions, but it has also recovered quickly

No forecasting tool is perfect. The 10-year and 3-month Treasury rates actually inverted in 1966 with no subsequent recession. In addition, while the inversion in June 2019 was followed by a recession in February 2020, that downturn was caused by COVID-19. The bond market cannot predict global pandemics, so that inversion may have been coincidental.

However, if the current yield curve inversion does indeed signal a recession, history says the stock market will decline sharply. The chart details the peak decline in the S&P 500 during each recession since 1968.

Data source: Truist Advisory Services.

As shown, the S&P 500 has declined by an average of 34.5% during recessions since 1968. That sounds alarming, but readers should bear in mind two things.

First, there is no guarantee a recession will follow the current yield curve inversion. The bond market could be sounding a false alarm. Second, the stock market is forward-looking in nature, such that the S&P 500 has historically recovered four or five months before recessions have ended, according to JPMorgan Chase.

The stock market has also rebounded quickly in the past. After reaching its peak decline during the last eight recessions, the S&P 500 returned an average of 42% during the following year. In that context, it would be very risky for investors to sell stocks right now to hedge against a possible recession. That strategy could easily backfire because it would be impossible to predict the S&P 500's rebound.

So while the bond market is currently sounding its most severe recession alarm in decades, there is no guarantee a recession will ever materialize. And even if it does, the most prudent course of action is to stay invested because market timing strategies could lead to missed opportunities.