JPMorgan's quant guru says an inverted yield curve and a hawkish Fed warrant caution from investors, but a recession is still unlikely

• A yield curve inversion and aggressive rate hikes by the Federal Reserve warrant caution from investors, according to JPMorgan's Marko Kolanovic.
• Despite those worries, the US economy is unlikely to enter a recession, he said in a Monday note.
• "Recessions usually don't start before inversion and the market typically peaks only a year afterwards," Kolanovic said.

Investor concerns about yield curve inversions and Federal Reserve interest rate hikes are warranted, but that doesn't mean a recession in the US economy is likely, according to JPMorgan's quant guru Marko Kolanovic.

A yield curve inversion, in which short-term interest rates are higher than longer-term interest rates, has historically been a good leading indicator that the economy is on the verge of entering a recession. That's because an inversion typically indicates that financing conditions have tightened to an unsustainable level for companies to raise debt.

In recent weeks, the curve of the 2-year and 10-year Treasury rates has flattened significantly after the Fed raised interest rates for the first time since late 2018. The 2-year yield currently sits at 2.30%, just 18 basis points shy of the 2.48% 10-year yield.

"Crucially, the flat/inverted yield curve was historically a good cycle signal because it would indicate that financing conditions have become highly restrictive, but we do not see this at present," Kolanovic said in a Monday note.

In other words, as high inflation and historically low interest rates keep real borrowing costs down, Kolanovic doesn't see Fed rate hikes restricting a company's ability to raise debt at an affordable interest rate.

"Real rates averaged +200bp at the time of past curve inversions, vs current negative levels, while bank lending standards are still easing," Kolanovic explained.

While the closely followed 10-year/2-year yield curve gets closer to an inversion, the 10-year/3-month yield curve, which has also been a reliable indicator of future recessions, is moving in the opposite direction. That's sending mixed signals to investors about the possibility of an imminent recession, according to Kolanovic.

"Recessions don't typically start ahead of the curve inverting. From the point of curve inversion to the actual peak of the equity market, which typically takes place around a year later, S&P 500 was higher by 15%. The clock has not started ticking yet," Kolanovic said.

And while the Fed has recently signaled that 50-basis-point rate hikes are a possibility at its upcoming meetings to tame inflation, previous tightening cycles have usually resulted in a rising stock market, according to the note.

"The start of hikes is typically accompanied by some market volatility, but this initial weakness ultimately gets absorbed, and the market moves higher. We still believe that recession should not be seen as a base case, even in Europe," Kolanovic said.