The Bond Market Is Sounding an Alarm That May Signal a Stock Market Crash -- but It Comes With a Silver Lining for Investors

Experts have waffled on whether the U.S. economy is headed for trouble. In October 2022, economists put the probability of a recession within 12 months at 63%, according to The Wall Street Journal. Inflation exceeded 8% at the time, and the Federal Reserve was raising interest rates at the fastest pace in decades. But the situation has changed dramatically since then.

Inflation has cooled to the point where policymakers are expected to cut rates in September, and the economy has continued to expand. U.S. gross domestic product (GDP) increased at an annualized 2.8% in the second quarter, while experts forecast just 2% growth. Economists now put the probability of a recession within 12 months at 28%. But investors are not out of the woods.

Bloomberg recently published an opinion piece by Bill Dudley, the former president of the Federal Reserve Bank of New York. The headline speaks for itself: "I Changed My Mind. The Fed Needs to Cut Rates Now." Dudley believes the economy is already slipping toward a recession, and that delaying rate cuts until September unnecessarily increases the risk.

A bond market forecasting tool supports that conclusion. The Treasury yield curve has predicted every recession since 1969, and it has been sounding an alarm for 21 months, the longest on record. Should that warning prove accurate, a recession would almost certainly lead to a stock market crash.

The Treasury yield curve has been a remarkably accurate recession forecasting tool for more than five decades

U.S. Treasury bonds are debt securities that pay a fixed interest rate (or yield) based on when they mature. Treasuries with long maturities typically pay more than Treasuries with short maturities because investors expect greater compensation when committing money for longer periods. For example, 10-year Treasuries typically carry a higher yield than three-month Treasuries.

However, the yield curve becomes inverted when short-dated Treasuries pay more than long-dated Treasuries. Inversions frequently appear when economic uncertainty pushes investors to purchase bonds with long maturities. Since bond prices and yields move in opposite directions, heavy demand for a long-dated Treasury would cause its price to increase and its yield to fall, potentially leading to an inversion.

Inversions between the 10-year and three-month Treasury bonds are especially noteworthy because that portion of the yield curve has been a reliable recession forecasting tool. "The yield curve has predicted essentially every U.S. recession since 1950 with only one 'false' signal, which preceded the credit crunch and slowdown in production in 1967," according to the Federal Reserve Bank of New York.

The current yield curve inversion is the longest on record, meaning the economy is "overdue" for a recession

Since 1969, the U.S economy has suffered eight recessions. All of them were preceded by a yield curve inversion involving the 10-year and three-month Treasuries.

Data source: Federal Reserve Bank of New York, National Bureau of Economic Research. The chart above shows the correlation between U.S. recessions and yield curve inversions. The dates listed for yield curve inversions correspond to the first month in which the average yield on the three-month Treasury exceeded that of the 10-year Treasury.

As shown above, Treasury yield curve inversions have historically preceded recessions by no more than 16 months. But the current inversion recently became the longest on record. It started 21 months ago in November 2022, meaning the U.S. economy is "overdue" for a recession.

There is another important data point. The average term spread -- the difference between the yields on the 10-year and three-month Treasuries-- exceeded negative 1% in June 2024. The last time that happened (excluding the current inversion) was August 1981. In other words, the bond market is not only sounding a recession alarm, but it's the most severe recession alarm in decades.

The S&P 500 has typically crashed during recessions, but there is a silver lining for investors

Economic downturns have historically been bad news for the stock market. The chart below shows the peak decline in the S&P 500 (SNPINDEX: ^GSPC) during each recession since 1969. In most cases, I think it's fair to say recessions have coincided with stock market crashes.

Data source: Truist Advisory Services.

As shown above, the S&P 500 has declined by a median of 35% during recessions since 1969. The index currently trades 4% below its record high, so the implied downside would be 31% if a recession started tomorrow.

That sounds alarming, but the worst thing investors can do is attempt to time the market by selling stocks now and buying again before the rebound. No forecasting tool is infallible, so the current yield curve inversion does not guarantee a recession, nor does it guarantee a stock market crash.

Additionally, even if the stock market does crash, the S&P 500 has historically rebounded before recessions have ended. "In every recession of the past 50 years -- except the tech wreck in the early 2000s -- the S&P 500 began its climb back to highs before economic activity troughed," according to J.P. Morgan strategist Elyse Ausenbaugh. "In the median occurrence, the market rally began four and a half months before GDP found its low point and generated 30% upside in that period." In other words, investors who attempt to time the market could easily miss out on big gains.

That brings me to the silver lining. The S&P 500 has recovered from every downturn in history, and there is no reason to think the next one will be different. In that sense, the next stock market crash could actually be a tremendous buying opportunity. Some Wall Street analysts see artificial intelligence (AI) as one of the largest investment opportunities in human history. But unchecked enthusiasm has left many AI stocks trading at pricey valuations. A stock market crash could give investors another bite at the apple.

For instance, shares of Alphabet, Amazon, and Microsoft dropped more than 30% during the last bear market, and shares of Nvidia and Advanced Micro Devices plunged more than 60%. Similar declines are possible during the next market crash, meaning investors could likely buy stock in those AI companies at tremendous discounts to their current prices.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Trevor Jennewine has positions in Amazon and Nvidia. The Motley Fool has positions in and recommends Advanced Micro Devices, Alphabet, Amazon, JPMorgan Chase, Microsoft, and Nvidia. The Motley Fool recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.

The Bond Market Is Sounding an Alarm That May Signal a Stock Market Crash -- but It Comes With a Silver Lining for Investors was originally published by The Motley Fool