Market Update April 2022 – Yield Curve Inversion ≠ Stock Aversion

CAPITAL MARKETS

The first quarter of 2022 required investors to process two significant crosswinds facing the capital markets, the Russian invasion of Ukraine and the Federal Reserve’s plans to begin normalizing interest rates following an era of low, crisis-fighting rates.  Just digesting one of these issues would be expected to create a difficult environment for both the global economy and capital markets.  Yet, despite rising volatility in 2022 to-date, many global economies and markets have weathered this initial storm better than expected.

Of course, this new era of global conflict and rising interest rates is still taking shape.  Initial expectations of Russia’s invasion had been described by most in terms of weeks and months.  Today, expectations of this war’s longevity are now open-ended.  And early concerns of rising inflation coincided with the growing belief that the Federal Reserve would combat this through new policy initiatives, including raising benchmark interest rates.  Against this backdrop, global markets saw investors reduce risk in response to the growing uncertainty.  Yet following the initial reaction, much of the global economy has fared better than early expectations. 

The primary economic cost for the broader global community has come through the building stresses in the supply chain, causing inflationary pressures that had been a concern even before this war began.  As inflation has now become more evident, it is being stressed further due to continued strength in global demand.  This has presented a different dynamic than had been felt earlier this century when falling demand had been a central condition in an economic slowdown/recession (e.g., demand faltering due in part to rising unemployment during the “Great Financial Crisis”).  Today, the central economic concern is strong demand, economic strength, and the attendant inflation rather than weakening demand and growing unemployment.  And it stands to reason that a different type of problem requires a different solution.

The current supply-driven challenges have tested the thinking of the Federal Reserve regarding the use of monetary policy tools intended to balance the need to control inflation without causing undue stress within local economies and the capital markets.  This is a delicate balance as supply constraints are found not only in both goods and services, but also in labor, a twist that hasn’t been part of the equation in recent recessions.  The Federal Reserve’s choice to confront this primarily through interest rates and shrinking the balance sheet (unwinding GFC’s bond buying program) is intended to moderate demand with the hope of bringing it more in-line with supply, which would be expected to calm inflation. 

For now, the Federal Reserve has some room to use interest rates as a tool to calm the inflationary impulse before recessionary conditions become a concern.  The current economic dynamic of demand strength outpacing available supply suggests relatively stable corporate earnings, which would be supportive of the equity markets.  But the path is likely to be more volatile and require greater selectivity by investors.  As first quarter earnings are announced, investors may see corporate leadership attempt to moderate future expectations – still healthy but tempered.  And investors may find that the equity markets’ decline during Q1 2022 has already accounted for these adjusted future expectations. 

As we are facing the initial stages of this process the primary risk is that rate-hike cycles have historically been prone to go too far before being discontinued.  But these risks are likely aways from going too far.  At best, the “data dependent” Fed brings interest rates back to a level more conducive to long-term economic health, with both demand and supply constraints moderating.  At worst, they overshoot the target and economic growth slows further than intended.  A fluid, but not an easy task.

CHART OF INTEREST: Yield Curve Inversion ≠ Stock Aversion !?!

The Federal Reserve (Fed) has made it publicly known that they intend to fight inflation and while there are many nuances regarding the actions they will take, most will have an impact on interest rates.  This has caused some angst with investors as rising rates can adversely affect the economy.  Markets have already begun to reprice US Treasuries based on the combination of inflation expectations and now the actions of the Fed. 

For the Fed, it’s a tricky process to raise rates without going too far and choking off economic growth.  If investors sense that they are expected to go too far or too fast, it can result in an inversion of the yield curve.  Otherwise said, if the Fed’s actions cause investors to lose confidence in future economic growth, the market may see longer term interest rates move lower than that of shorter terms. This unusual condition doesn’t happen often, but when it does, it has been a signal warning of potential of recessionary economic conditions on the horizon.  And economic concerns like this also affect other markets such as the stock market.

Using the example of the relationship between the two-year Treasury and the ten-year Treasury (“2s10s”), investors would typically see a premium (i.e., higher interest rate) for the longer term ten-year versus the two-year.  But when this relationship inverts, history says that a recession may well be on the horizon.  It just doesn’t know how soon, how deep, or how long it may last, but this condition has occurred before all but one recession over the last sixty years.

What does this mean for the stock market?  Surprisingly, less than one would think.  The chart below looks at the performance of the S&P 500 Index following this yield curve inversion signal over the following 3-, 12- and 18-month periods.  And what is apparent is that the signal for an economic recession is not necessarily one for the stock market.  In five of the seven cases, stocks were higher during the inversion (the length of the actual inversion may be counted in day or months as each episode has been unique). In five out of seven cases the stock market was higher in the 3 months following the inversion and in the twelve and eighteen months following the inversion. Only two of the seven cases (1980 and 2000) eventually saw losses.

Does this history mean smooth sailing?  Certainly not.  At best, it suggests that the inverted Treasury curve’s signal of recession does not alone dictate equity losses.  And while history says the odds are in favor of equity gains going forward, it’s likely that the path will require increased selectivity as the choppy markets of 2022 may persist for some time.

S&P 500 Index: Periodic Total Returns

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