Merely two months ago, the stock market stamped the inauguration of a fresh bull market.
Reaching a pinnacle of 4,839.81 on Jan. 19, the S&P 500 surged to its loftiest height, preserving the upward momentum, with a year-to-date surge of over 10% at current rates.
Infused with zeal, investors have embraced this nascent bull market, emboldened by the flourishing domain of artificial intelligence (AI) and the Federal Reserve’s vision of receding interest rates. The easing interest rates typically lubricate the economy, fostering a conducive borrowing environment that fortifies multiple sectors, including real estate, automobiles, and financial institutions.
Yet, within this apparent exuberance, a cadre of economists remains resolute in their conviction about an impending recession. Notably, two cardinal indicators are vehemently signaling a looming recession. Let’s explore the nuances of each and dissect their repercussions on the economic landscape and the stock market.
Image source: Getty Images.
The Yield Curve Inversion: Navigating Turbulent Waters
If you’ve been monitoring the stock market, the concept of the yield curve inversion may have crossed your path. This phenomenon materializes when the long-term bond interest rates dip below the short-term rates.
Traditionally, interest rates ascend with extended bond maturities, as investors demand heightened compensation to retain fixed-income assets over prolonged durations. The inversion of the yield curve typically arises amidst anticipations of imminent interest rate reductions, a scenario often triggered by the Federal Reserve slashing the crucial fed funds rate to stave off a recession or mitigate its impact. The rapid increase in interest rates witnessed in 2022 by the Federal Reserve, akin to levels unseen since the ’80s, aimed to counter the soaring inflation wave of that era. The aftermath witnessed a downturn, the yield curve inversion, and widespread recession speculations.
The inversion of the yield curve, usually gauged by the variance between the 2-year Treasury yield and the 10-year yield, has historically foreshadowed a recession with unerring accuracy dating back to 1966. Despite the absence of a recession on that occasion, GDP experienced a precipitous decline.
Since July 2022, the 2/10 yield curve has remained inverted, with the divergence amplifying in recent weeks, as depicted in the illustrative chart below.
2 Year Treasury Rate data by YCharts
Evidently, investors anticipate an impending rate cut by the Fed, often a testament to a weakening economy.
The Sahm Rule: A Bellwether for Economic Shifts
Another widely-acknowledged recession indicator that appears poised to unfurl the scarlet banner is the Sahm rule. Crafted by former Fed economist Claudia Sahm, this rule asserts that if the three-month average unemployment rate ascends by 0.5 percentage points from the nadir noted within a year, a recession looms on the horizon.
February witnessed the unemployment rate escalating to 3.9% despite sturdy job expansion, marking a half-percentage point escalation from the April 2023 3.4% reading. Though the three-month average teeters below the recession-triggering threshold, February’s figures flirt dangerously close to it, hinting at the impetus a robust March reading might provide to surpass the inflection point.
The Sahm rule has successfully prophesied every recession in modern U.S. annals, as upticks in the unemployment rate frequently herald profound job losses consequent to an economic downturn. The graphical illustration below delineates the correlation between unemployment rate upsurges and recessionary cycles.
US Unemployment Rate data by YCharts
Charting Uncharted Territories: Deciphering the Current Conundrum
In the realm of investments, the assertion “this time is different” often ensnares individuals. Pivotal tenets of economics and investor conduct tend to replay themselves, culminating in asset bubbles, and prices along with valuations reverting to the average. Nevertheless, several rationales underpin the belief that the economy might sidestep a recession amidst the ominous indicators.
Primarily, we are toeing the line of the longest span bridging the commencement of a yield inversion to the onset of a recession, tracing back to at least 1978. This nuanced observation underscores the bearish indicator’s historical unresponsiveness in the current scenario.
Moreover, a typical yield curve inversion ensues amidst investor perceptions of a slackening economy. However, in the present scenario, the inversion unfolded within a bear market triggered by Fed rate hikes to combat inflation. This deviation from the usual trends introduces an element of disruption in the indicator’s foreseeability.
Regarding the Sahm rule, even though the unemployment rate lingers at a historically low ebb, standing below 4%, the data is veiled with noise due to labor force contraction stemming from the pandemic’s implications. Equally paramount, the persistent vigor in job creation portends a formidable labor market resilience. Sahm herself iterated that her rule had yet to sound the alarm, underlining the imperative nature of tracking the three-month average.
Additional observations hint at a plausible continuum of economic expansion. The AI upsurge has spurred a frenzied tech sector chase, manifesting in elevated funding for new tech infrastructure and a hiring spree in affiliated roles. Consumer confidence has manifested an upward trajectory post-mid-2022, a departure from the traditional trend preceding recessions. Moreover, the advent of a novel bull market signifies economic sanguinity amid predictions of a recession.
Buoyed by the protracted run extending beyond the yield curve’s prophetic realm and the prevailing low unemployment rate, my bet is on the economy gliding past the recessionary precipice.
Nevertheless, irrespective of the unfolding scenario, it’s vital for investors to retain cognizance that recessionary phases are inherent within the economic cycle fabric. Fed Chair Jerome Powell’s December reminder about the lurking recession risk further underscores this reality.
A historical glance at the U.S. stock market reveals its resilience post every recession, encompassing ordeals such as the Great Depression, Global Financial Crisis, and the COVID-19 pandemic. This historical vantage point should embolden investors to remain steadfast in their investment pursuits, irrespective of short-term permutations.