Will rising interest rates crush the bull market in equities? We recently concluded that rising rates are not a deal breaker, as long as earnings accelerate faster than the discount rate. Earnings have kept their end of the bargain so far. But let’s keep thinking.
While rising interest rates alone have not determined the fate of equities, the shape of the yield curve has. The chart below shows that, over the past four decades, an inverted yield curve (blue line below black line) has always preceded major bear markets associated with economic recessions (shaded areas).
Today’s 10-year-minus-2-year spread is positive 1.20%. Assuming 25bp rate hikes and holding 10-year Treasury yield constant, it would take five Fed tightening moves to invert the curve. Too early, then, to project a major top based on this method, even if we relax our assumptions.
Note however, that several important tops occurred without this signal – e.g. 1987, 1998, and 2011. These episodes weren’t “major” bear markets, but gut wrenching nonetheless. Who knew in 1987 that a major bull market remained intact?
Bottom line? Stocks go down in anticipation of recessions, but also for other reasons. No indicator is perfect, but this one is definitely worth watching.