Forget the yield curve. Morgan Stanley says investors should be focused on a superior recession signal — one that’s threatening to flash by year-end.

Forget the yield curve. Morgan Stanley says investors should be focused on a superior recession signal — one that’s threatening to flash by year-end.


Unless you’ve been living under a rock for the past several days, you’ve probably been swept up inyield curve mania.

Friday marked a momentous occasion for the bond market, as the spread between 3-month and 10-year US Treasurys slipped into negative territory — or “inverted” — for the first time since 2007. This set offrecessionwarning sirens across Wall Street, andstocks took a tumble.

The trepidation was understandable. After all, a negative relationship between those two yields is one of the foremost indicators of an impending economic meltdown. As the chart below shows, such an inversion has preceded every recession since 1975.

Read more:The stock market just got hit with a vicious trifecta that could accelerate its next major meltdown

Morgan Stanley

ButMorgan Stanleysays there’s a more nuanced — and accurate — way to assess whether a recession is coming. The firm notes that although a 3-month/10-year inversion has always occurred before a recession, the curve was not flipped in the 10 days prior to the start of the last three instances.

Morgan Stanley instead identifies rate cuts from theFederal Reserveas a more compelling recessionary signal.

The firm has studied the last seven recessions and found that in 1982 — in between the fourth and fifth economic contractions on a chronological basis — the Fed unofficially switched its approach to rate decisions. The central bank began targeting the federal funds rate.

“While the yield curve has a proven track record, another indicator has recently been as good at preceding US recessions: Fed rate cuts,” Matthew Hornbach, global head of interest rate strategy at Morgan Stanley, wrote in a client note. “Ever since it began targeting rates, the Fed has cut them ahead of recessions.”

Read more:Stocks just traded like they do right before recessions begin — and one of Wall Street’s biggest bulls warns a ‘big test’ of the worst-case scenario could fail

Further, Morgan Stanley finds that the Fed has historically conducted its first pre-recession rate cut 169 days before each meltdown began in earnest. Using last Friday as a starting point, that would put us on schedule for a recession by December 2019.

Hornbach is quick to note that economists within Morgan Stanley are actually forecasting a 25-basis-point rateincreasein December. But he says that forecast is highly subject to change, especially if economic data is weak in the coming months.

With all of that established, stock investors are probably wondering what this all means for them. They saw how violently the market reacted on Friday when the curve inverted. What might happen if the Fed cuts rates? Shouldn’t that theoretically be positive for equities, since accommodation has helped catalyze the10-year bull market?

Not so fast, says the equity strategy team at Morgan Stanley. If the Fed does get to the point where a rate cut is the best way forward, it will be because the economy is struggling mightily. They argue that when the economy is looking downright rotten — as opposed to simply sluggish — that’s bearish for stocks.

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In addition, Morgan Stanley says the Fed’s pivot towards an easier monetary policy created a “false sense of confidence” for investors, which could be setting the market up for disaster. And at the center of its bearish view is the negative impact corporate earnings revisions will have on stocks.

“4Q results were quite poor and led to the broadest earnings revisions we’ve observed since the last earnings recession in 2015-16,” Mike Wilson, Morgan Stanley’s chief US equity strategist, wrote in a client note. “Stocks rallied sharply on that bad news, but rather than a signal the worst is behind us, we think the rally was mostly the result of the Fed’s actions.”

He continued: “As we have be writing for the past month, we think 1Q results next month could lead to similarly negative revision breadth, if not worse. With the Fed now ‘all in’ and stocks already fully valued, we think betting on another ‘look through’ quarter is a bad risk reward.”

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