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Since 2022, a key indicator in the bond market, which often predicts an impending recession, has continued to flash red continuously. This situation, known as a Inverted yield curve, marks the longest period of inversion ever recorded.
Normally, the yield curve is rising, which means that long-term rates are higher than short-term rates. Investors expect more compensation for the higher risk and longer maturity of long-term bonds. An inverted yield curve occurs when short-term rates are higher than long-term rates, which is often seen as a signal of economic slowdown or recession. This is because investors expect future interest rates to fall in response to a weakening economy.
Inverted yield curve (source: FRED)
Previously, an inverted yield curve often preceded recessions, as seen before the economic downturns since the 1960s. For years, investors have relied on this indicator to adjust their expectations for the economy. However, this time around, no prolonged economic contraction has been observed, despite the yield curve falling for a Record period reversed Remains.
Greg Obenshain, partner and director of credit at Verdad Advisers, points out that equity investors usually become alert when an inverted yield curve turns into a steeper yield curve. This is because a steeper curve often goes hand in hand with negative stock returns, as Interest rate cuts of the Federal Reserve are usually a response to an economic downturn. However, Obenshain notes that the central bank foresees interest rate cuts this time around to ensure a soft landing of the economy, not to support a weakening economy.
According to Obenshain, it is possible that the yield curve will remain inverted for a while or only slowly steepen without anything serious happening to the economy. This scenario is different from what Historically is customary.
Verdad's researchers have shown that certain safe havens, such as Utilities, real estate funds and government bonds, outperform during yield curve inversions. This is because investors are becoming more pessimistic about the economic outlook and are resorting to safer investments. Chris Satterthwaite, senior analyst at Verdad, argues that U.S. equities, especially in the utilities and real estate sectors, have been one of the best performing market segments during periods of yield curve inversion since 1996.
On the other hand, riskier assets such as small-cap stocks and emerging market stocks have outperformed when the yield curve steepened, indicating a more optimistic economic outlook among investors.
Nanette Abuhoff Jacobson, global investment strategist at Hartford Funds, argues that the traditional rule of thumb of the inverted yield curve has not proven reliable this time around. She points to strong government and consumer spending and the enthusiasm around artificial intelligence, which helped prevent a recession.
This year, U.S. shares have delivered impressive performances, driven by mega-cap technology companies. However, the real estate sector of the S&P 500 is the worst performer this year, while the utilities sector has seen a notable increase, thanks in part to its focus on artificial intelligence.
According to Abuhoff Jacobson, a chain of events would be needed for defensive stocks to outperform the broader market during yield curve inversions. This includes factors such as prolonged restrictive policy by the Fed, pressure on corporate earnings, or a rise in the unemployment rate above 4.5%.
Despite the persistent inverted yield curve and its historical association with recessions, an economic downturn is not yet certain in the near future. Investors remain focused on economic indicators and the Federal Reserve's policy decisions, while the stock market continues to react to yield curve dynamics.
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