Veteran political consultant James Carville once explained the power of the bond market, in his typically colorful way:

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

The Ragin’ Cajun was correct. The bond market is a strong leading indicator. And right now, the bond market is trying to warn us.

U.S. stocks have rallied in recent days, lifting the S&P 500 out of correction territory and within 3% off its record high. The bond market, on the other hand, is flashing a yellow caution light.

After an 11% surge over the past two weeks, the rally in U.S. stocks is taking a breather. The main U.S. indices Wednesday declined as follows: The Dow Jones Industrial Average -0.19%; the S&P 500 -0.63%; the NASDAQ -1.21%; and the Russell 2000 -1.97%. In pre-market futures trading Thursday, U.S. stocks were little changed.

Bank stocks have taken it on the chin lately. One would think that in a rising rate environment the well-capitalized banks would be gaining ground, but fear of an inverted yield curve has held them down.

The difference between 10-year and 2-year yields this week inverted briefly for the first time since 2019. An inverted yield curve occurs when short-term interest rates are higher than long-term interest rates. An inverted yield curve is considered an indicator of recession. Indeed, an inverted yield curve has predicted every U.S. recession since 1995.

The 10-2 Treasury Yield Spread is the difference between the 10-year Treasury rate and the 2-year Treasury rate. A 10-2 Treasury spread that approaches 0 signifies a “flattening” yield curve. A negative 10-2 yield spread has historically been viewed as a precursor to a recessionary period (see chart).

With that said, since the late 1970s, the average time between an inversion and the actual onset of recession is 16.6 months. Historically, during those 16.6 months, the stock market has done quite well.

Consequently, while the narrowing yield curve is certainly worth monitoring, the threats it indicates are well off into the future.

The business of war…

The news from Eastern Europe also is troubling. We’re getting conflicting signals about Russia-Ukraine peace talks. The Russians claim progress, but the Ukrainians insist that the Kremlin is making unacceptable demands.

Read This Story: Peace Talks Unleash The Bulls

Russia this week said it would curtail military operations, which temporarily cheered investors, but then the country launched fresh attacks. War headlines are translating into market volatility, as shifting conditions of the Russia-Ukraine conflict whipsaw investors.

Russian President Vladimir Putin badly miscalculated by invading Ukraine and his military decisions appear increasingly desperate. As the Russia-Ukraine quagmire enters its sixth week, the world is in greater danger of nuclear war than at any time since the 1962 Cuban Missile Crisis.

Amid this geopolitical anxiety, aerospace/defense stocks have been rising and they’re on track for further significant gains. Military-oriented equities benefit from international tensions, but they also serve as inflation hedges and they’re immune to pandemic headwinds. They’re recession-resistant as well, especially as Western defense budgets get boosted because of vulnerabilities posed by Putin’s revanchism.

I work as a freelance analyst with the aerospace/defense consulting firm Teal Group. Over the years, I’ve seen first-hand that military contractors enjoy a powerful lobbying presence in Congress, regardless of which political party is in control. The Pentagon never has to rattle a tin cup.

In recent weeks, the Russia-Ukraine war has sparked a multi-billion-dollar rearmament surge among Western countries, especially NATO leaders such as Germany.

Germany’s recent departure from its pacifist post-Nazi stance is sending reverberations throughout the Continent. Germany is the biggest economy in Europe and its policies exert outsized influence. Germany, and accordingly other NATO countries, are about to go on a shopping spree.

President Biden this week proposed a fiscal year 2023 budget that includes $813 billion in spending for national defense, a 4% increase of $31 billion from the spending package signed into law earlier this month.

The defense budget boosts we’re seeing at home and overseas will mostly end up in the hands of U.S.-based defense giants…and their shareholders.

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John Persinos is the editorial director of Investing Daily.

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