• Wealth Management

Is the Bond Market Signaling a Recession?

When short-term and long-term bond yields are almost the same, recession often follows. Here’s why this time may be different.

Investors have plenty of market risks to keep in mind. Earnings growth may be peaking, the Federal Reserve indicates it will continue to raise rates and trade tensions show no signs of abating. I have noted recently that inflation could rise and stock market leadership could shift.

However, there is one bearish indicator many investors are focused on that I think could be getting overplayed: That’s the flattening yield curve.

Yield curve analysis is a little esoteric for the average investor, but it’s bread and butter for market strategists like myself. The yield curve is simply a chart comparing the yields of short-term government bonds (usually two-year Treasury notes) and long-term government bonds (10-year notes). In a healthy, growing economy, long-term bonds typically yield more than short-term bonds and the yield curve slopes upwards. But when investors get concerned about economic growth, long-term bond yields tend to fall and the yield curve flattens.

Currently, there is only a quarter of a percentage point difference between the two-year and the 10-year Treasury note, down from a spread of more than three quarters of a percentage point in February. That’s a fast pace of flattening. If it keeps up, the yield curve could invert, or short-term bonds could yield more than long-term bonds. Historically, when that happens, a recession is often about a year away.

That may sound unsettling. But I think the yield curve might not be that useful as a gauge of recession risk this market cycle. Monetary policy, demographics and global economic forces are all part of the explanation. But the key point to understand is that there is huge, ongoing demand for high quality, long-term Treasuries. That may be keeping 10-year bond yields unusually low (bond yields move inversely to prices), distorting the signal the yield curve is sending.

At the same time, there are other bond market indicators that are more reassuring. If we look at a different measure, the short-term yield curve (the difference between three-month bill and an estimated 18-month yield) we see that it is actually positively sloped, signaling economic growth could continue. Also, the market for corporate bonds (both investment grade and high yield) has declined some, but at a very gradual and orderly pace, which doesn’t suggest investors are seriously concerned about the health of the economy.

Bottom line: While I pay close attention to the yield curve, I think there is a chance it is distorted by global macroeconomic conditions that are unique to this market cycle. I think it may be too soon for investors to scale back on equities in their portfolios. My recommendation now is to stay in stocks, but emphasize more defensive sectors, such as consumer staples, telecom and utilities rather than technology. Resist the temptation to get bearish based on the yield curve alone.