When These Two Things Coincide, It Doesn’t Bode Well For Stocks

When These Two Things Coincide, It Doesn’t Bode Well For Stocks
Stéphane Renevier, CFA

5 months ago1 min

An inversion in the yield curve – when long-term yields are unusually lower than shorter-term ones – is often seen as a bad omen. That’s because it often happens when the Federal Reserve (the Fed) raises short-term interest rates to pump the brakes on the economy.

These inversions have an exceptional track record at anticipating recessions, but what they don’t tell you is when the recession will hit, as the curve often remains inverted for an extended period before a recession emerges. For a better sense of timing, you may want to look at when the curve steepens after an inversion.

But be warned: there are two ways the curve can steepen:

It can “bear steepen” – where long-term interest rates rise faster than shorter-term ones.

It can “bull steepen” – where long-term interest rates fall faster than short-term ones.

A bull steepening has historically been a bad signal for the economy and for stocks as it happens when investors are expecting a slowdown in economic activity that’s sharp enough to warrant rate cuts by the Fed.

But, interestingly, currencies trader and author Brent Donnelly has found that a bear steepening that happens while the yield curve is inverted (blue bars) can also be a dependable indicator that a recession (pink bars) and a correction in stocks (black line) are in the making.

Of course, there are lots of other factors that drive the economy and the stock market’s performance. But with the curve currently inverted and bear steepening, you may want to consider yourself warned.

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