Ned Davis Research: "There are three big risks that can "break" the stock market and the economy"

The US stock market is in a pronounced corrective phase after a sustained appreciation in the early months of the year, but the US economy is shaping up impressively after a brief slowdown in 2022. US GDP estimates for the quarter the third are of more than 5% growth, and the world's largest economy has created more than two million jobs so far this year, writes Business Insider. According to the investment research firm Ned Davis Research, there are three risks that, if materialized, would "break" the stock market and put an end to the current growth cycle of the American economy, the source also notes.

• The return of inflation

Inflation is decelerating and moving slightly toward the Federal Reserve's 2 percent target after peaking at 9 percent last June, but a resumption of rising prices would threaten the trajectory of the current Fed policy tightening cycle, according to Business Insider.

"A strong rise in inflationary expectations has traditionally caused a widening of the spread between long-term and short-term bond yields, which would put additional pressure on nominal yields," said Joseph Kalish, principal global strategist of the NDR.

Kalish monitors US five- and ten-year inflation swaps, which help him measure inflation expectations. The strategist is concerned that the five-year swap is just a few basis points below the 2022 high. But crossing that threshold would be cause for concern that inflation may rise, according to Business Insider.

• Ten-year government bonds yield to rise above 5.25%

The yield on 10-year US Treasuries has risen so far this year, hitting a sixteen-year high of 5.02% on Monday. The continuation of this upward trend would cause problems for the economy as a whole, especially if the yield exceeds the level of 5.25%, according to Ned Davis Research, writes Business Insider.

"The 5.25% yield was a major double-top in 2006/2007 and coincided with the interest rate peak of that policy rate tightening cycle. So, we wouldn't look at breaking that level lightly," Kalish said. High interest rates raise the cost of borrowing for consumers and businesses, often reducing demand, leading to slower, if not contraction, economic growth.

• Deterioration of credit conditions

So far this year, the bond market has been more concerned with interest rate risks than credit risks, according to Business Insider. However, changing this perspective would be bad news. In Kalish's opinion, although the differences between the yields of bonds with similar maturities but different credit qualities (credit spreads) have increased slightly, they are still "tight" and credit conditions are still favorable for the economy in general.

That's because companies are generating cash flow in an expanding economy, and interest payments remain low, writes Business Insider. But, widening credit spreads would be the first warning sign that investors should look out for as it could eventually affect the equity market and the economy.

"A larger spread would suggest a much weaker economic environment and a high risk of default. When investors start to care more about credit risk than interest rate risk we will enter a new, more disruptive phase of the business cycle," Kalish said, according to Business Insider.