Three Risks Threatening the U.S. Economy and Stock Market

In spite of the schism in the stock market, the American economy has been charting an impressive course of growth since its momentary slowdown last year. Projections for the third quarter of this year suggest a GDP surge exceeding 5%, and the U.S. labor market has managed to swell by more than 2 million jobs year-to-date.

Nonetheless, there are three ominous shadows casting doubt on the sustainability of this growth cycle, as per a Tuesday report from Ned Davis Research. Let’s delve into these critical concerns.

1. A Revival of Inflation

Inflation has been striving to make amends, endeavoring to align with the Federal Reserve’s steadfast 2% target after Consumer Price Index (CPI) rates peaked at approximately 9% last June. However, a resurgence in soaring prices could perturb the Federal Reserve’s current tightening strategy.

Joseph Kalish, Chief Global Macro Strategist at NDR, underscores that “a breakout in inflation expectations has traditionally caused an increase in the term premium, which would put further upward pressure on nominal yields.”

What raises eyebrows is that the 5-year inflation swap, a yardstick for inflation expectations, lingers just a hair’s breadth away from its 2022 zenith. Any sudden upswing in this indicator could signify the potential for higher inflation rates.

2. The 10-Year Treasury Yield Breaching 5.25%

The 10-year U.S. Treasury yield has been on a relentless upward trajectory this year, cresting at a 16-year high of 5.02% on a fateful Monday. Should this pivotal benchmark rate surge further and breach the 5.25% threshold, it could spell woes for the overall economy.

Kalish explicates,

The 5.25% yield level was an important double-top in 2006/2007, and also represented the peak policy rate of that tightening cycle. So we wouldn’t take a break of that level lightly.

Elevated interest rates augment borrowing costs for consumers and businesses, a development often synonymous with reduced demand, leading to a slowdown in economic growth or, at worst, a contraction. As of Tuesday, the 10-year U.S. Treasury yield had already reached 4.86%.

3. Credit Conditions on the Downturn

Throughout this year, the bond market’s primary concern has been interest rate risks, overshadowing credit concerns. However, if this trend takes an abrupt turn, the implications could be dire. While credit spreads have experienced slight expansion, they remain, in the words of Kalish, “subdued,” and credit conditions remain amenable to the wider economy.

The favorability of credit conditions hinges on companies generating substantial cash flow within an expanding economic landscape and relatively low interest rate payments.

Nevertheless, a looming scenario in which credit spreads start to inch upwards is a forewarning that investors should not ignore, as it could ultimately cast a pall over both the stock market and the broader economy.

In Kalish’s words,

A higher spread would suggest a much weaker economic environment and increased default risk. When investors start worrying more about credit risk than interest rate risk, we will enter a new and more troubling phase of the economic cycle.