Mitch on the Markets

March 4th, 2024

Why The Currently Inverted Yield Curve Isn’t Triggering A Recession

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Why the Inverted Yield Curve Hasn’t Led to a Recession in this Cycle

Over the past 70+ years, nearly every U.S. recession has been preceded by an inverted yield curve. Historically, any time the yield curve inverted for a period of at least two months, a recession followed within the next 18 months.1

The chart below makes this relationship clear – the red circles indicate yield curve inversions, and the gray bars show the recessions that followed. Readers can see how closely the two have correlated historically.

Recessions Historically Follow Yield Curve Inversions

Source: Federal Reserve Bank of St. Louis2

The current cycle, however, appears to be playing out differently.

The yield curve – as measured by the difference between the yield on the 10-year U.S. Treasury bond and the 3-month U.S. Treasury bond – first inverted in October 2022, and since then the U.S. economy has not only continued expanding but also accelerated in some periods.

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The U.S. economy has averted recession for now, but the longer the yield curve is inverted the higher the chance that bank lending activity could start feeling negative impact.

To keep up with the latest trend of the yield curve as well as ever-shifting economic fundamentals, I recommend keeping an eye on reliable, up-to-date data to ensure your portfolio is allocated appropriately. So today, I’m offering our March 2024 Stock Market Outlook, which provides detailed insights, such as:

• The Importance of Asset Allocation
• Zacks Rank S&P 500 sector picks
• Current asset allocation guidelines
• Zacks forecasts for the months ahead
• Zacks Rank industry tables
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Before digging into this disconnect, it’s important to understand the yield curve in terms of its impact on credit—which is the fuel that keeps the economy humming.

When the yield curve is upward sloping, it means short-term borrowing rates are lower than long-term lending rates for banks, which creates positive net interest margins and makes it profitable to lend. When the yield curve is inverted, however, the opposite is true – banks have to borrow at high short-term rates, which creates profitability issues with lending and tighter credit conditions for the economy. When credit and lending activity dries up, economic activity tends to follow.

In the current cycle, however, higher short-term rates have not had a major impact on bank profitability or lending activity over the past year. The reason: banks are still flush with deposits.

Deposits at Commercial Banks Surged After the Pandemic and Remain at High Levels

Source: Federal Reserve Bank of St. Louis4

In a sense, the Fed’s aggressive rate hike campaign did not put banks in the unwelcome position of having to borrow at increasingly higher short-term rates. Banks had – and continue to have – plenty of cash on hand. To be fair, deposit rates have started going up at banks recently, and increased competition for deposits could become an impediment to bank profitability. But in my view, the Fed is likely to start cutting rates before that becomes a concern.

In the meantime, credit has been flowing in the U.S. economy. Recent declines in long-duration Treasury yields have led to a surge in investment-grade corporate bond issuance, which is running at a record pace so far in 2024. And despite worries that last year’s regional bank stress would cut off major sources of lending, banks have been loosening lending standards in recent months. In the chart below, the percentage of banks tightening lending standards for mid-size and large business commercial loans (blue line), loans to small firms (red line), and auto loans to consumers (green line) have all fallen.

The Net Percentage of Banks Tightening Lending Standards Has Fallen Recently

Source: Federal Reserve Bank of St. Louis5

Bottom Line for Investors

Consumers have already taken falling, long-duration interest rates as a prompt to increase their borrowing. Mortgage applications are up, and we’ve seen much higher issuance of asset-backed securities – which are bonds backed by debt like credit cards and auto loans – rising materially in 2024.

The yield curve inversion will eventually unwind, but the key question looking forward will be how that happens. The Fed could start cutting rates later this year to bring the short end of the curve lower over time, while the economy continues to expand. This would in turn give banks additional options for lending, and we could see even more meaningful increases to credit flowing in the economy – a harbinger for more growth ahead.

If you’re looking for more insight into what’s next for the market, I recommend downloading our March 2024 Stock Market Outlook Report6, which contains some of our key forecasts to consider, such as:

• Zacks Rank S&P 500 sector picks
• Current asset allocation guidelines
• Zacks forecasts for the months ahead
• Zacks Rank industry tables
• Buy-side and sell-side consensus at a glance
• And much more!

If you have $500,000 or more to invest and want to learn more about our market forecasts for 2024, click on the link below to get your free report today!

Disclosure

1 Wall Street Journal. February 14, 2024. https://www.smh.com.au/business/markets/the-danger-sign-that-has-the-world-on-edge-20240213-p5f4fo.html

2 Fred Economic Data. February 26, 2024. https://fred.stlouisfed.org/series/T10Y3M#

3 Zacks Investment Management reserves the right to amend the terms or rescind the free-Stock Market Outlook Report offer at any time and for any reason at its discretion.

4 Fred Economic Data. February 23, 2024. https://fred.stlouisfed.org/series/DPSACBW027SBOG#

5 Fred Economic Data. February 5, 2024. https://fred.stlouisfed.org/series/DRTSCILM#

6 Zacks Investment Management reserves the right to amend the terms or rescind the free-Stock Market Outlook Report offer at any time and for any reason at its discretion.

DISCLOSURE

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

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This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney-client relationship. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole.

Any projections, targets, or estimates in this report are forward looking statements and are based on the firm’s research, analysis, and assumptions. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions are subject to change without notice. Clients should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed in this presentation.

Certain economic and market information contained herein has been obtained from published sources prepared by other parties. Zacks Investment Management does not assume any responsibility for the accuracy or completeness of such information. Further, no third party has assumed responsibility for independently verifying the information contained herein and accordingly no such persons make any representations with respect to the accuracy, completeness or reasonableness of the information provided herein. Unless otherwise indicated, market analysis and conclusions are based upon opinions or assumptions that Zacks Investment Management considers to be reasonable. Any investment inherently involves a high degree of risk, beyond any specific risks discussed herein.

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