The 10Y-2Y yield curve broke above the key level of -0.4% and that means a double-bottom pattern is in play. While we are confident that a major steepening cycle is here, we have to acknowledge that the nascent move could fail. A steepening move is also the market’s way of signaling easier conditions ahead.
Frequently, there’s money to be made in the stock market in the months following the initial curve inversion. After the inversions of August 2006 and June 2019, the S&P 500 rallied another 23% and 19%, respectively, into its final bull market high. If this cycle plays out in textbook fashion, the business-cycle peak would arrive in September.
Market veterans know there’s just one thing more probable than a recession after the yield curve inverts: Yield curve denial among a large group of sell-side economists and market strategists! Indeed, the earliest of those dismissals occurred last March—a month before the first of more than a dozen iterations of a yield curve inversion.
Last month’s inversion in the 10-Yr./3-Mo. Treasury spread further tilts an already lopsided scale in favor of a U.S. recession in 2023. That spread has been considered the gold standard from an economic forecasting perspective, and is the basis for the New York Fed’s Recession Probability estimate (which, by the way, should break above its critical 35% threshold when it’s published later this month.)
The main yield curve drivers—fiscal and monetary policies—might be suggesting a steepening move is coming soon, while bank stock performance may also be hinting at a turn in the curve. However, a durable selloff in the U.S. dollar would be needed to support a steeper yield curve, so the tightening pain could last a while longer.
In a simple test of 15 yield-curve variants, we found that the 2s10s spread ranks second to last, based on its correlation with one-year-forward real-GDP growth since 1978. The three best measures employed the 3-month bill as the “short” rate. The spread between the 5-year note and 3-month bill showed the strongest correlation with subsequent economic growth.
The U.S. 10/2-year curve just fell below the key threshold of 50 bps. Over the last 25 years, the yield curve proceeded to invert after this “Rubicon” was crossed. That doesn’t mean imminent trouble. The lead time of a yield-curve signal is lengthy, but it—and real yields—definitely warrant close monitoring.
We can’t count the number of times in the last week we’ve heard analysts worry about “what the Fed might know that we don’t.” In the words of John McEnroe, “You cannot be serious!”
A way to gain perspective on the present is by trying to view it from the future. Ask yourself, “What are the signs of impending decline, now ignored by investors, that will one day be memorialized by the same investors as the most obvious in retrospect?”
This year’s upswing in money-supply growth has been one of many factors that’s prevented our economic work from triggering a recession warning. Following a two-year decline, year-over-year growth in M2 bottomed near 3% late in 2018 and has trended upward all year, reaching 6.7% in the latest week (Chart 1).
The yield curve’s ten-month moving average inverted in September, hence the yield curve inversion can no longer be dismissed as transitory; the Boom/Bust Indicator remains below its descending 10-month moving average, confirming economic weakness predicted by the yield curve; and, the “Present Situation” component of September’s Consumer Confidence survey slipped below its 10-month moving average for the third time in 2019.
We always do our own work and draw our own conclusions. Lately, though, we’ve wondered what the late “Monetary Marty” Zweig might say about the stock market’s current liquidity backdrop.
Over a 12-month horizon, we now believe a U.S. recession is very likely, but aren’t confident enough to make the call when the forecast window is cut in half. Second-half stock returns could be decent if the business-cycle peak is still a year away. Then again, there’s peril in waiting for “too much” confirmation of recession.
While the celebration over Jerome Powell’s “Christmas Capitulation” lingered throughout February, we’re still awaiting signs the capitulation consisted of anything more than words.