You’ll Know A Correction Is Coming When This Signal Flashes

You’ll Know A Correction Is Coming When This Signal Flashes
Stéphane Renevier, CFA

over 1 year ago1 min

We’ve written before about why you should be worried about an inversion in the yield curve: it’s historically signaled with almost uncanny accuracy that a recession is on the way. What it doesn’t predict though is when the recession will hit, or when stocks will fall as a result.

But there is one signal that may help with that: a “bull-steepening” in the yield curve. The curve is said to be bull-steepening when the 2-year US government bond yield drops by more than the 10-year bond yield.

While this is good for bonds (their price goes up when yields fall – hence the “bull” part), it’s not so good for stocks. That’s because a bull-steepening tells us that investors are starting to worry about the overall economy, and are increasingly expecting the Federal Reserve to have to cut interest rates to soften the blow from a recession.

And if stocks love lower rates, they hate a downturn, as it shrinks companies’ earnings and pushes valuations lower. As you can see on the chart, the sharpest corrections in stocks (shaded blue areas) have happened during a bull-steepening that follows an inversion (where the black line begins to rise sharply after crossing the zero line).

And while the yield curve hasn’t bull-steepened yet, with the curve so far below zero, it may happen sooner rather than later…

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