S&P 500 Could Be up for a Major Correction

Recession warning from the yield curve might negatively impact stocks
Bonds offer refuge, with an average of 10% returns after the Fed’s first rate cut

The End of the Yield Curve Inversion

One of the most reliable recession indicators over the last 5 decades, the yield curve, is flashing recession warnings.

In response to weaker labor market data and the potential for Fed rate cuts, the yield curve (10-year Treasury yield minus 2-year Treasury yield) has returned positive for the first time in over two years.

Source: Morgan Stanley

Historically, that signal (the un-inversion) has preceded the start of each recession like a shadow.

Ok, maybe not always, except in cases where the duration was “lightning quick” (few weeks).

This occurs because market participants, anticipating future rate cuts to combat a downturn, drive long-term rates lower.

What does that mean for the US Economy?

Historically, there’s been about a 7-month lag on average between the first inversion and the onset of a recession.

If history is any guide, the prolonged inversion we experienced could set the stage for another economic downturn.

Source: Goldman Sachs

S&P 500 returns, on average, are rather low, around 2%, in the first month following the un-inversion and -2% in the next half-year.

Even if the economy avoids a recession 3 months after a yield curve un-inversion, the average return is around 1%, and 6 months after, the average return is around 2%[1] – not impressive at all.

So what are the investment alternatives?

The time for bonds has arrived

Following the first Fed cut, bonds averaged 10% returns.

Source: Edward Jones

Fixed income returns are a function of duration, which refers to a bond’s sensitivity to interest rate changes.

Falling rates would typically cause long-term bond prices to rise.

The easing Fed cycle is precisely what will drive lower rates.

The Fed’s Next Move

The Federal Reserve has been in a rate-hiking cycle for over two years now, but Fed chair Powell has implied that lower rates are coming.

A slowdown in the labor market has raised concerns about a wider economic decline.

The first cut is anticipated to come at the September 18 FOMC meeting, with a reduction of 0.25%, rather than 0.5%, quite likely given the hotter-than-expected inflation data yesterday.

Conclusion

Some market participants hope that lower rates will stave off a recession.

It’s important to remember that rate cuts work with a lag or take time to filter through the economy.

Markets, on the other hand, are forward-looking mechanisms, and some, especially in the fixed-income space, offer very accurate signals of what’s coming next.

Owning high-quality and less economically sensitive assets like bonds should add some cushion in case economic and earnings growth tumble.

Investors can long the 500 largest stocks in the US using our 3x US 500, 5x US 500.

Alternatively, traders can short the 500 largest stocks in the US using our -3x US 500.

Investors can long-duration bonds using our 5x 20+ Year Treasury Bond.

Alternatively, traders can short the long-duration bonds using our -5x 20+ Year Treasury Bond.

Footnotes:

Goldman Sachs

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