The bond market is doing something we haven't seen in decades. It could indicate a problem in the stock market.

Many economists expect the United States to suffer from a recession last year. Economists surveyed The Wall Street Journal In late 2022, the odds of a recession were estimated at 63%. The prevailing logic was that the Fed would raise interest rates too much, which would lead to a significant reduction in spending that would translate into high unemployment and economic contraction.

Instead, the economy remained strong in 2023 despite strong interest rate increases and higher inflation. Economic growth actually accelerated last year, supported by strong (if slower) increases in consumer spending and business investment. The economy is currently expected to expand at an annual rate of 2.9% in the first quarter of 2024, higher than the 10-year average of 2.5%.

In short, recession fears have faded. Many economists now believe the Fed will move the needle and have a soft landing, meaning policymakers will tame inflation without sparking a recession. quotes Morgan Stanley “The US economy is on a roll, with almost all data confirming a soft landing,” analysts said.

Yet the Treasury market — a recession forecasting tool with a near-perfect record — still sounded its most dire alarm in decades. Recessions have usually coincided with a significant decline in… Standard & Poor's 500. Here's what investors should know.

Treasuries have predicted previous recessions with near-perfect accuracy

US Treasury securities are debt securities issued by the government. They pay a fixed interest rate until their maturity date, at which point the bondholder gets the principal back. The interest rate (or yield) is usually higher on long-term bonds than on short-term bonds. So the yield curve usually slopes up and to the right.

However, the yield curve becomes inverted (starting high and sloping downward whenever it is true) when long-term bonds pay less than short-term bonds. This can happen during periods of economic uncertainty. Some investors hedge against recession risk by purchasing long-term bonds to obtain guaranteed returns over an extended period of time. Demand for those long-term bonds causes prices to rise and yields to fall.

For example, the 10-year Treasury currently pays less than the 3-month Treasury, which means that part of the yield curve is inverted. What makes this noteworthy is the almost perfect accuracy with which these bonds have predicted previous recessions. Specifically, an inversion between the 10-year and three-month Treasury yields has preceded every recession since 1969, with only one false positive in the mid-1960s.

Treasuries are doing something investors haven't seen in decades

The chart below lists the start date of every yield curve inversion involving the 10-year and 3-month Treasury notes since the late 1960s, and the start date of subsequent recessions. The graph also shows the amount of time that elapsed between the two events.

Data source: Federal Reserve Bank of New York, National Bureau of Economic Research. The chart above shows the relationship between U.S. recessions and yield curve inversions involving 10-year and 3-month Treasuries.

The 10-year and 3-month Treasury yields have inverted before every recession since 1969, with no more than 16 months between the inversion and the subsequent recession. For context, the current coup began 15 months ago in November 2022, implying that the United States could slide into recession by the end of next month.

There is another point that investors should take into consideration. The current yield curve inversion was steeper in May 2023, when the average yield spread (10-year Treasury yield minus 3-month Treasury yield) fell to -1.71%. The yield curve has not inverted sharply since June 1981, when the average yield spread was -2.04%.

The curve has flattened since May 2023. The average yield spread was -1.3% in January 2024, but this still represents the lowest reading since August 1981, when the average yield spread was -1.43%. In this context, Treasuries are doing something that investors have not seen in decades. In fact, a blog post from the Federal Reserve Bank of St. Louis says that “the implied probability of recession would be unprecedentedly high if the result were a false positive.”

Stocks typically fall sharply during recessions, but tend to rise sharply before recessions end

The S&P 500 is typically viewed as a benchmark for the broader U.S. stock market. Since its inception in 1957, the US economy has experienced ten recessions, during which the S&P 500 index fell by an average of 31%. In other words, if the economy slides into recession this year, history says the stock market will suffer a major decline.

This may seem very concerning, but investors should avoid selling their shares. In fact, the wisest course of action is to stay invested and keep buying good stocks at reasonable valuations. I say that for three reasons. First, the bond market has been wrong in the past. Yields on 10-year and 3-month Treasury notes flipped in January 1966, but this event was not immediately followed by a recession. The current yield curve inversion, although serious, may be another false positive.

Second, even if the economy is in recession, investors who sell will not know when to buy again. The S&P 500 typically rebounds about four or five months before a recession ends, and the index has historically returned an average of 30% between its bottom and the end of a recession, according to C. B. Morgan Chase. Investors who try to time the market will likely miss out on some of these gains.

Third, despite several recessions since 1994, the S&P 500 has returned 10.3% annually over the past three decades. Investors could achieve similar returns over the next three decades even if the economy suffers a recession this year. But any attempt to time the market can backfire, setting investors up for long-term underperformance.