The big selloff in June was followed by an equally impressive rally in July, with the S&P 500 index recovering almost all the losses racked up in June. The bond market was just as exciting. The 10-year yield fell more than 30 bps and ended the month at 2.67%. With its 50-day moving average starting to turn lower, the U.S. 10-year yield seems to have peaked for the year. The big reversals in both stocks and bonds came after market pricing for rate hikes peaked in mid-July.
Meanwhile, U.S. yield curves continued to flatten in July and Chart 1 shows the nature of the move has gone from a bear flattener (high yields, flatter curves) to a bull flattener (lower yields, flatter curves). In our last report we stated that “we expect a volatile grind lower in rates over the summer, and the yield curve to flatten/stay flat until the Fed pivots from its aggressive stance.” That is largely what happened in July, but at an accelerated pace.
In March we observed that, over the last 25 years or so, the yield curve had proceeded to invert once the 10-2 year curve fell below the 50-bps threshold. This time is no different but it has happened much faster than the historical pattern suggests (Chart 2).
Our interest is in the market implications of a yield-curve inversion, however, the definition of an inversion still depends on which part of the curve one looks at. For example, while the entire yield curve has flattened and most parts of it are now inverted, the best yield curve measure in terms of predicting a recession—the 10Y-3M curve—is still positive (not inverted).
Therefore, to get a more robust historical definition of yield-curve inversion, we use the majority rule of the three most popular measures: 10Y-2Y, 10Y-3M, and 5Y-2Y. Chart 3 shows the historical instances of inversions by this characterization. Over the past 40 years prior to the latest case in July, there were six occurrences in which both the 5Y-2Y and the 10Y-2Y curves inverted. The duration of previous inversions ranged from four to 21 months, with a median of 12 months.
As we mentioned, bond yields appear to have peaked for the year. This is entirely consistent with the historical pattern where rates typically start to roll over after inversion* (Chart 4). The yield curve, on the other hand, also seems to be close to an inflection point after reaching inversion—a curve-steepening move usually follows (Chart 5).
Taking Charts 4 & 5 together, the yield-curve dynamic is apt to change from bear flattening (higher rates, flatter curves) to bull steepening (lower rates, steeper curves) fairly soon. It’s probably time to start the count-down to a bull steepener, where the short end comes down more than the long end. This often occurs when the Fed is near the end of its tightening cycle and the market starts to look ahead to a new easing cycle. Chart 6 shows that’s precisely the driver for a switch to a bull steepener—the next Fed move after an inversion is normally a cut!
While we certainly don’t expect a cut at the next FOMC meeting in September, we believe the current market pricing of an early-2023 Fed cut is not unreasonable. By then, the ongoing economic slowdown will have been material enough to justify a Fed pivot or even a cut. If history is any guide, economic activities slow even further after an inversion (Chart 7). Recent industrial production numbers certainly point in the same direction.
In our last report we laid out a set of key indicators that might tell us how close we are to a Fed pivot. Our take is that while most market-based measures suggest a Fed pivot pretty soon, the Fed’s dual mandate, inflation and employment, will likely keep the Fed’s hands tied. Currently, both are still far too strong to justify an imminent pivot. Does a yield-curve inversion change anything? Probably not. Chart 8 shows the typical pattern for the CPI around the start of an inversion. Inflation tends to persist for a while and peak around six months later. The inflation surge this year is certainly much worse than the historical pattern, and the Fed will have no choice if it doesn’t moderate soon.
Employment typically deteriorates a bit after an inversion as initial jobless claims start to edge up. Recently, we have seen an uptrend developing, albeit from a very low level (Chart 9). Hiring freezes and layoffs are becoming more commonplace and job openings have plunged too. The combination of stubbornly high inflation and worsening employment is probably the most tangible aspect of a stagflation environment.
As we all know, a yield-curve inversion normally occurs close to major economic and market turning points. Historically, credit tends to sniff out impending trouble first, and spreads widen way ahead of a stock market selloff. That’s very consistent with the patterns in Charts 10 & 11. The S&P 500 is usually untroubled by the implications of an inversion, while the credit market braces itself for impact. This time around, however, equities actually led credit in the selloff. There are a couple reasons for that. First, high inflation is good news for credit, all else equal. Borrowers get to pay back with less money in real terms, thus reducing their default probabilities. Second, most of the Fed’s emergency backstops installed at the depth of the COVID-19 crisis, including various facilities for short-term funding and credit markets, are still in place. This truncated the left-tail risk of credit but also made credit far less sensitive to macro-economic risks and thereby less useful as a leading indicator.
Equity styles respond to inverted yield curves as well. Value tends to underperform Growth after an inversion (Chart 12). Banks/Financials—a big presence in most Value indexes—are usually the most vulnerable cohort when a yield curve inverts. The same thing happened this time. Banks and Financials have significantly underperformed since February, as the yield-curve flattening move accelerated (chart not shown). Energy, another heavyweight in Value indexes, propped up the performance for most of the year. However, the recent correction in Energy stocks suggests recession concerns have finally started to overtake inflation fears. If the historical pattern holds, more challenges lie ahead for Value.
Small-cap stocks generally underperform their large-cap counterparts around a yield-curve inversion and are not likely to outperform until the Fed pivots/reverses course (Chart 13). So far this year, small stocks have underperformed but, overall, their relative performance has been in a wide trading range. Remember, the most unfavorable seasonal period is not over until October.
Despite all the issues we have in the U.S. we should consider ourselves lucky, as foreign markets have fared even worse this year. Chart 14 shows U.S. stock-market leadership is very consistent with the historical pattern and the trend is unlikely to end anytime soon. Obviously, the stellar strength in the U.S. dollar helped, and it’s quite common for the dollar to strengthen around a yield-curve inversion (Chart 15).
Real asset performance varies quite a bit around an inversion. Charts 16 & 17 show commodities generally outperform gold prior to an inversion but underperform afterward. This is in line with our expectation that recession concerns are likely to outweigh inflation worries going forward.