Weekly Update

Yield Curve Inverts but Recession Still a Ways Off

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Published April 8, 2022


The recent inversion in the yield curve has certainly generated a lot of headlines. The inversion occurs when short-term interest rates become higher than long-term interest rates. The driver of the inversion is usually a Federal Reserve raising rates while investors are skeptical about the long-term economic strength. Thus, the interest rate curve reflects a sort of temporary spike in rates. This inversion often suggests a recession is upcoming as the economic cycle has overheated to the point where the Fed has had to step in to slow it down. The Fed has a history of being late to act to the overheating economy, then putting on the brakes too hard, and the economy suffering a bit as things adjust back to a more normal economic pace.

The data below shows the stock market’s reaction to an inverted yield curve. There is some predictive power in the inversion. But it is a leading indicator of about 12 to 18 months (aka it is ahead of the actual event by that much time). The first two tables focus on that lead time and stock market reactions.

SPX move from yield curve inversion to the market peak

Wide distribution of outcomes after historical yield curve inversions

Driving the Fed’s newly aggressive approach to interest rates is stubbornly high inflation. While most people tend to focus on the easily-seen hikes in food and energy costs, the chart below shows that food and energy costs represent a relatively modest fraction of the average person’s monthly spending (15-20%).

Consumer spending on energy and food

What really causes inflation to stick around is higher wages. We know that wages are rising for the first time, collectively, in decades as there is a serious shortage of workers. The pandemic has upended the economy in all kinds of ways. The abrupt shift in workers is perhaps the most pervasive and likely long-lasting economic impact. A shortage of workers leads companies to pay their existing workforce more in order to retain who they have on board. This makes the wage inflation “sticky” as long as the shortage exists.

Another consequence of the pandemic has been the dramatic shift to work-from-home workers. This has not only emptied out buildings in some communities as office space is no longer needed. The work-from-home folks tend to spend less money as the chart below shows. This, of course, has significant economic impacts.

Work-from-home folks tend to spend less money

So, we can envision the economy taking a hit as this major adjustment plays out. Office space gets repurposed as apartments(?), ghost kitchens, and other new uses. Workers return to the workforce but in different jobs and in different industries. The supply chain shortage has been exacerbated by the war in Ukraine and could last longer than anyone guessed. It is a lot for the economy to adjust to.


Market Update

Investors looked this week to the publishing of minutes from the Fed’s most recent meeting as markets are completely focused these days on the Fed’s path for raising interest rates. Monday kicked off the week with strength, a +1.9% rally in tech shares helped along by Tesla head Elon Musk’s disclosure that he owns a stake in Twitter. Stocks gave all of that back Tuesday when Fed Governor Brainerd outlined an aggressive plan for the Fed to reduce its balance sheet. In addition to setting the short-term interest rate benchmark, the Fed has been very active in purchasing bonds since the pandemic as a way to support markets. Investors have known the Fed would be scaling back these purchases, thereby removing one of the market’s major players. It was the size of the scaling back that shocked investors Tuesday to send stocks tumbling. The selloff continued Wednesday with the actual release of the Fed minutes. A second day of -2% losses for the high-growth Nasdaq as interest rates shot higher. Further selling in stocks opened the market Thursday before an afternoon recovery brought indexes back to close slightly positive. Stocks showed weakness again Friday though the losses were modest. Interest rates posted their sixth straight day of higher yields. The 10-year bond has gone from 2.4% to 2.7% over those six days.

The stock market’s rally stalled last week, after two positive weeks, then rolled over this week. The S&P 500 (SPY) slid -1.18%. The Nasdaq 100 (QQQ) lost -3.51%. Smallcaps (IWM) gave back -4.67% to remain the weakest index of the group.

Warm wishes and until next week.