Amidst some evident risks, the market continues to rise steadily. The Federal Open Market Committee is set to announce its monetary policy decision on Wednesday. However, the chances of a rate cut appear to be minimal, and futures suggest that there is less than a 50% probability of Jerome Powell and his team lowering rates in March. Despite these uncertainties, the market seems largely unfazed by the upcoming announcement.
The latest earnings reports have portrayed a mixed picture. Companies like Tesla and Intel experienced significant drops after their releases, while others such as Netflix saw their stocks soar. Looking ahead, investors do not seem overly concerned about the upcoming reports from Apple, Amazon.com, Microsoft, and Alphabet.
Interestingly, the stock market even celebrated positive economic data, disregarding its potential implications for the Federal Reserve. In the previous week, the fourth-quarter U.S. gross domestic product surpassed expectations, registering an annualized growth rate of 3.3% instead of the forecasted 1.8%. This unexpected strength in economic performance spurred a rally in stocks, particularly among small-cap companies. Furthermore, Citigroup strategist Scott Chronert highlights that the firm’s U.S. Economic Surprise Index and the S&P 500 have been moving in tandem recently, which bodes well for the market. He explains, “Importantly, the equity market reaction has been positive to better-than-expected macro data.” It appears that bad economic news may no longer be interpreted as good news for the equity market, as was the case in the latter half of 2023.
The Warning Signs in the Market
Investors should be wary of the recent developments in the market. One area of concern is the Treasury market. While the two-year yield fell slightly to 4.345% last week, the 10-year yield increased modestly to 4.14%. As a result, the gap between the two yields has narrowed to just 0.2 percentage point, the smallest it has been since late 2022 (excluding a brief moment at the end of last year). This tightening of the yield curve, which measures the difference between short- and long-term rates, indicates an imminent “un-inversion.”
Traditionally, long-dated yields are higher than short ones as investors expect greater compensation for tying up their funds for longer periods. An inverted yield curve, where short-term yields surpass long-term ones, is often seen as a warning sign for an impending recession. Conversely, an un-inverted yield curve suggests that the market anticipates a future decrease in interest rates and potentially stronger long-term growth.
However, an un-inversion does not necessarily bode well for stock markets. Historical data reveals that the stock market declined in three out of eight instances when the yield curve un-inverted after being inverted for at least three months. In fact, there were two occurrences of drops exceeding 10% within the subsequent 12 months.
While it is not definite, an un-inversion may even foreshadow an oncoming recession, although the likelihood seems low at present. Typically, a slowdown materializes around nine months after the yield curve reaches its maximum inversion. Given that this peak occurred in mid-2023, it implies that a recession might arrive sooner than later.
BCA Research strategist Doug Peta asserts, “The U.S. is going to have a recession in 2024.” He adds, “I do think the market is going to have the rug pulled out from under it.”
Even without a recession, a decline in the S&P 500’s performance could be problematic. Currently, the index sits 22% above its 50-day moving average, which signifies that it is significantly above its recent trend. This situation has frequently preceded noteworthy declines in recent years, highlighting the potential risks ahead.
The Lurking Threat: A Bear Market on the Horizon?
Amidst the calm demeanor of the market, a whisper of caution begins to circulate, urging us to contemplate the possibility of an impending painful setback. While the bear may not be growling loudly enough to send shockwaves through the financial world, it would be wise for cautious investors to start paying heed to the potential risks.