Stocks typically outperform for a long time even when the bond market is flashing recession signal

Even so, the inversion has occured and analysts see reason for some caution. But Bespoke co-founder Paul Hickey said stock investors should not panic over the preliminary inversion of the curve.

“Just looking at it, I don’t think that by itself it’s a major short-term concern. You have to see how things play out. There were some exceptions where you didn’t see a recession, but typically you saw one in the next year or two,” he said.

Before Friday, the 3-month yield had not risen above the 10-year yield in 3,030 days. Bespoke studied the S&P 500 in perios where there was a long period, of 500 days or more between inversions.

In the month after the first day of the inversion, the S&P gained 1.74 percent, and was higher five out of six times. Over the next six months, the index averaged a gain of 6.75 percent, but it was up only half the time. In the year after the last four inversions similar to the current one, the S&P was positive each time with a gain of at least 9 percent.

Analysts also said they would watch to see if the move is sustained or just temporary. “If we start to see it steepen again right away, it could get ignored,” said Hickey. “If we see it get further and further inverted, that would be something that would obviously be a cause for concern. We have a week left in the quarter and if we see earnings warnings from companies start to pick up that would be something to worry about.”

Hickey said market returns are often good when the curve first inverts, but it gets wobblier once the curve begins to steepen again. “It typically steepens because the Fed is cutting rates,” he said. At that point, the short end rates fall with the fed funds rate.

Source: Bespoke

The fed funds futures market is currently pricing in a 95 percent chance of a Fed rate cut this year, according to Mark Cabana, head of U.S. short rate strategy at Bank of America Merrill Lynch. The market is pricing in more than two more cuts next year.

That’s a big shift from just several months ago when rate hikes were expected it both years. The Fed now forecasts no more hikes this year, down from its previous forecast of three as recently as the fourth quarter.

Cabana said BofA does not expect a recession this year, but the inversion is something to watch.

“As recession signals begin to flash, and recession probabilities increase, I would expect market participants and people who deploy capital will become more cautious and there’s a risk that is a self-fulfilling prophecy,” he said.

Cabana said when the 3-month and 10-year have first inverted, the length of time between that inversion and a Fed rate cut has been long and varied, ranging between 14 and 400 days in periods since 1992.

“This is a Fed that has been quite dovish. They have shown they are willing to bet quite proactive, and they try to get ahead of things, and I would think this type of a Fed could very much be persuaded in that direction,” he said.