Market Update July 2022 – Is a Caution Sign Flashing?


Investors regularly look for signals that may provide clues to “what’s next” in both the global economy and capital markets.  Technology has made data widely available, providing the opportunity to scan history for periods which may be similar to today and helpful in understanding future risks and rewards.  However, many studies have confirmed the difficulty investors have judging various potential signals in an unbiased manner, resulting in biases toward a predetermined outcome.

For those examining how to apply history to the current landscape, many unique characteristics are perceived to be flashing a “caution” sign.  This is currently evident in many data points, particularly those used in popular analyses of interest rates as signals for the equity markets.  Most common tends to be the relationship of long-term and short-term interest rates as expressed by the spread between the two-year and 10-year Treasury notes.

Typically, longer term bonds offer higher interest rates than shorter terms, accounting for the higher risk of a longer-term commitment.  But, when uncertainty is high and there is a growing threat of economic slowing, this relationship may flip.  And economic concerns often coincide with weaker equity markets.  It’s a popular condition discussed by market participants, but how reliable is it as a concern for equity markets?

The (very busy) chart below displays these relationships from June 30, 1976 through July 7, 2022.  The top section graphs the differential between the 10-year Treasury and two-year Treasury, followed by each of the 10- and two-year  interest rates for each of these Treasury notes in the middle section. Finally, the S&P 500 Index is depicted in the bottom section.  The vertical green bars notate dates when the difference between the two and ten year notes inverted, providing a high-level look at how reliable the Treasury inversion is as a signal for the S&P 500 Index (as a proxy for the broader equity markets).

A quick examination of this chart suggests that an interest rate inversion between the two- and 10-year Treasuries is inconsistent in signaling an equity market decline.  Looking at this chart alone, current conditions look similar to the inversions in 1988 and 2005-2006 during which equity markets did not experience significant drawdowns.  But it shouldn’t be dismissed altogether as each market era exhibits its own set of conditions and actions.  And, with the unique mix of geopolitical and economic concerns in 2022, markets will proceed down their own path, requiring investors to be flexible in using historical analyses of market and economic data as a road map for today.  Never say “This time is different” unless it is … 

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