Bonds Signal up to 60% Chance of Recession, Major Pain for Stocks

Earlier in 2019, the Federal Reserve announced a pause in its program of interest rate hikes, re-energizing the stock market in the process. Now the money market appears to be anticipating a cut in the federal funds rate before 2019 is over, which, in turn, suggests that the Fed is increasingly more worried about preventing a recession than combatting inflation. Deutsche Bank projects that the fed funds rate will end 2019 at 2.15%, implying a 60% chance of recession within the next 12 months, Barron's reports. The fed funds rate was 2.39% on May 20, 2019 and in a target range of 2.25% to 2.50%, per the Federal Reserve Bank of New York.

“The renewed trade tensions create downside risks which were deemed to be negligible 2 months ago,” Deutsche Bank observes. Meanwhile, other observers see heightened recessionary risk. For example, Paris-based investment banking firm Societe Generale has been pointing to negative signals from two indicators that they find to have excellent predictive track records historically, the yield curve and a proprietary measure of its own. The table below summarizes the key findings from Deutsche Bank.

Significance for Investors

“We are not encouraged by current trends and conditions [in the stock market], especially the renewed excess of optimism and stretched valuations,” strategists at Ned Davis Research wrote in a recent report, as quoted by Barron's. They say that investor sentiment must fall into “extreme pessimism mode” for the market to be on solid ground, and that outcome of the U.S-China trade negotiations will be key. The S&P 500 Index (SPX) closed at 2,86.36 on May 21, 2019, 3.0% below its all-time record high set in intraday trading on May 1.

David Rosenberg, chief economist and strategist at Toronto-based wealth management firm Gluskin Sheff, believes that past rate hikes by the Fed already have made a recession virtually a certainty, and that it's now too late to prevent an economic downturn by reversing course, Business Insider reports. His research indicates that 10 of the 13 previous cycles of rate increases by the Fed, or 77% of them from 1950 through 2006, ended in recession. The current cycle began in Dec. 2015.

Lower interest rates generally mean higher stock prices, all else equal. However, recessions often trigger bear markets. As a result, when declining interest rates are the result of rising recessionary pressures, they can be a bearish signal for stocks.

To be sure, expert opinion is sharply divided on the likelihood of an upcoming U.S. recession. Among the prominent observers who see no recessionary danger in the near future are Tobias Levkovich, chief U.S. equity strategist at Citigroup, and legendary investment manager Bill Miller.

Looking Ahead

Rosenberg suggests that investors keep a close eye on interest rates, especially since an inverted yield curve, in which short-term rates are higher than long-term rates, has preceded every U.S. recession since 1950. However, not every yield curve inversion has been followed by a recession, according to research by Bespoke Investment Group and Bianco Research.

Based on comparisons between the yields on 3-month and 10-year U.S. Treasury securities, the yield curve was inverted from March 22 through March 28, 2019, and again on May 13, per the U.S. Treasury Department. Bianco found that inversions only become reliable recessionary predictors if they last for 10 days or more.