Should an inverted yield curve scare off investors?

  • The 2-year Treasury yield dwarfs the 10-year Treasury yield.
  • Yield reversals have historically preceded recessions.
  • Stocks can still rise in the year following a reversal.

Stocks don’t rise or fall in a straight line and reversals (pulbacks or rallies towards support or resistance, respectively) can be breathtaking. Yet most reversals are just examples of the ubiquitous tug of war between profit seekers and profit takers in an established trend – nothing more, nothing less.

You can buy pullbacks in a rising market or sell rallies in a falling market. However, knowing whether to buy or sell is especially difficult when reversals occur near potential inflection points, such as the start or end of a bull or bear market.

In these circumstances, consulting the bond market can help because historically, the bond market is considered the smartest of the bond/equity family.

Unfortunately, the bond market does not seem very confident in the ability of the Fed to control inflation without harming the economy. This should make investors nervous, as a weak economy can mean a weak stock market.

In “It’s a story of two markets: stocks vs. Obligations“, says Maleeha Bengali:

“The dominant theme in the bond markets is that of inflation. He doesn’t trust the Fed, because the market feels the Fed is too late for the party, and the movement at the front of the curve falls much faster than at the back, a process called flattening, which is usually synonymous with bearish or recessionary. markets”.

This market wariness is evident in the yield spread between 10-year and 2-year Treasury bills. The gap between the two is a meager 0.03% on March 29, compared to 1.56% a year ago (Note: the gap was -0.06% at noon on April 1).

The compression of the 2/10 spread suggests that bond participants believe short-term rates will spike causing inflation to pull back, then the Fed will have to shift gears and cut again due to the slowdown economy. (The 10-year yield should be higher than a 2-year yield because investors demand a higher yield to offset the opportunity cost and inflation).

Back to Bengali:

“The higher the market prices are ahead, the more the bond market expects further cuts in the future. This is the reasoning used by the stock market to tolerate further buying. But truth be told, the market bond investor doesn’t trust the Fed because he knows very well that the Fed is about 500 basis points behind the curve and needs to tighten aggressively, he also knows that the Fed can’t support the markets as long as inflation has not returned to its 2% average.

A rock and a hard place?

It is crucial to watch the 2y/10y yield spread for a reversal as it has been a good harbinger of the recession. 2/10 inversions have preceded every recession since 1955, including all six recessions since 1980 (recessions reflect two consecutive quarters of negative GDP growth).

According to the previous chart, a reversal does not bode well.

If a recession is looming (and some say it is inevitable), the recent stock market rally could be a painful simulation at the end of the quarter.

In the short term, stocks can be pushed and pulled in different directions, particularly at the end of a quarter when advisors and large funds make changes that will be reflected in quarterly updates to clients.

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As Bengali explains:

The March “quadruple witch” – when stock index futures, stock options, stock index futures options and stock index options expired – caused massive futures hedging and an upside breakout due to market derivative positioning. Keep in mind that month-end and quarter-end flows also tend to be important influencing factors. Judging by the performance of stocks versus bonds, selling bonds versus buying stocks also adds to this trend.

Window dressing may unleash animal spirits in short-term investors, leading to fear of missing out on buys, and it may help the recent rally. However, where the rubber meets the proverbial road will be if the rally continues into April after the quarter-end shakeup.

Another problem is that there is growing evidence that global consumers are close to a breaking point. For example, in the United States, inflation at 40-year highs caused a sharp drop in the widely tracked Michigan Consumer Sentiment Survey:

Graph Consumer Sentiment 040122

And it’s not just American consumers giving in. In the MORE Action Alerts morning update to members today, the AAP team wrote:

“Germany’s Gfk Consumer Confidence April figure came in at -15.5, which beat expectations of -11.2 and was well below March’s reading of -8.5. The March consumer confidence survey in France also matched medium-term lows at 91.0, which has not been seen since February 2021 and is boosted by inflation expectations from the Russia/Ukraine War We see these data points indicating that consumers expect the war in Ukraine to have a significant and ongoing impact on energy prices and, therefore, overall purchasing power While consumer spending accounts for about 67% of GDP in the US, it generates about 51% of GDP in Europe.”

This is important because if consumer spending falls due to inflation, S&P’s earnings estimates could be too high.

Back to AAP:

“We also note that despite all the factors that have unfolded in the current quarter, consensus expectations for the S&P 500 for the first half of 2022 have risen slightly from where they were in early January, paving the way for what could be a volatile market as the March quarter earnings season begins before too long.

If multinationals offer dire prospects in upcoming earnings reports, downward revisions to current expectations should follow, presenting another headwind to the recent stock market rally. However, we won’t know if earnings estimates will drop for the S&P 500 until most companies release, so a clearer picture won’t emerge until May.

Should investors run for the hills?

A possible reversal in 2/10 yields, slowing economic growth and lower earnings estimates are not a recipe for stock market gains, but there are a few other things you need to know.

For example, while reversals have occurred before every recession since 1955, there was a false signal in the mid-1960s (the economy slowed but escaped a recession). Also, it’s not like the 2/10 reversal leads to an immediate recession or stock market losses.

For example, it takes between 6 months and 24 months for a recession to emerge following a 2/10 reversal. And the average return of the S&P 500 in the 12 months following a 2/10 reversal has been 7.4% since 1978.

This suggests that selling willy-nilly due to a 2/10 yield reversal might not be your best decision.

A better approach might be to wait and watch the 3 month/10 year gap. It also has a strong track record of predicting recession, but unlike the 2/10, it is far from reversing:

Chart 10-year, 3-month spread history 040122

However, the typical return after a 3-month/10-year reversal is only 1.4%, so you’ll want to keep an eye on it if it starts to flatten out or reverses as well.

What about EQ?

Some wonder if the Fed’s quantitative easing (QE) program broke the 2/10 year indicator.

The Fed has purchased trillions of dollars worth of bonds at various maturities since the launch of QE in March 2020, and its purchases have helped cut 10-year rates, contributing to the flattening of the yield curve. That may not continue, however, as the Fed no longer replaces 100% of its maturing assets and it plans to start selling bonds soon.

Currently, the Fed holds $5.76 trillion in Treasuries, up from about $2.5 trillion in March 2020. Yet only about $1 trillion is in Treasuries with maturities of 5 to 10 years, and $1.4 trillion is in Treasury bills maturing in 10+ years. It sounds like a lot, but the Treasury market is huge.

If he sells the 10-year Treasuries in his portfolio, it could help steepen the curve by raising the 10-year yield, but that will only work if his sale is not met by an equal or greater number of buyers seeking shelter in bonds.

Here’s How Investors Should Play This

If you’re an active investor with a short time horizon, uncertainty means you’ll want to defend yourself, including limiting or avoiding leverage.

Use rallies to sell high-value stocks that perform best in the early stages of the business cycle when the Fed is cutting, not rising, and buy baskets that do better late-stage stocks, such as commodities, healthcare and utilities. A healthy cash position can also allow you to exploit short-term shifts in sentiment.

If you’re a long-term investor, consider increasing your exposure to defensive baskets, so that you match (at least) the exposure to the S&P 500. Next, review the amount you contribute to your retirement account. If you can increase the amount you invest each month, you’ll end up with more stocks at a lower average cost if the market drops over the next 12-18 months. This can boost your return when the market eventually goes up, as the S&P 500 averages an exceptional 38% in the first year of a bull market (the second year is below 12%).