- Investors are treading carefully after the 10-year/2-year yield curve briefly inverted on Tuesday.
- An inversion of the yield curve is widely viewed as a leading indicator that the economy is on the verge of a recession.
- But Fundstrat's Tom Lee gave three reasons why stocks are poised for more upside despite the inversion.
A brief inversion of the widely followed 10-Year and 2-Year yield curve on Tuesday set off alarm bells for investors, as an inversion is widely viewed as a reliable leading indicator that the economy is on the verge of entering a recession.
The yield curve inverts when short-term interest rates move higher than long-term interest rates, and previous inversions have occurred months before the 2020, 2008, and 2001 recessions.
But Fundstrat's Tom Lee gave three reasons why stocks likely have more upside ahead despite the inversion, and it has to do with the difference between nominal interest rates and real interest rates, which accounts for the current rate of inflation.
First, while nominal interest rates inverted on Tuesday, real interest rates didn't. In prior yield curve inversions, like in 2006 and 2019, both the nominal and real curve became inverted. "Real interest rate curve is still in normal slope," Lee said.
That's because inflation remains elevated. While the 2-year and 10-year treasury yields are around 2.4%, accounting for inflation rates, they are actually in negative territory.
Second, backwardation of inflation curves implies that the market sees inflation as "episodic," according to Lee, which can be seen in leading indicators like the Cass Freight Index, backup volumes at ports, and car inventories rolling over.
The episodic waves of inflation have been driven by supply chain disruptions, revenge-spending by consumers as the economy reopens, and now the ongoing invasion of Ukraine by Russia, which has led to a commodity price surge.
Finally, the "real" cost of 10-year money is still negative, which supports risk assets "as real borrowing costs [are] essentially free," Lee said. And negative real interest rates can lead to an expansion of stock multiples, supporting a further leg higher in stocks.
And during prior periods of negative real interest rates, stocks performed remarkably well. Those periods of time include the Roaring 20s and the post World War II economic boom.
"The good news is that in 2022, we have not seen the severe tightening of financial conditions that presaged calamity in 2006 and 2019," Lee said.
