Yield Curve is Bullish and Bearish for Stocks

With the continued consternation over the correlation of inverted yield curves leading to Recessions, it’s worth another look at the unusual dichotomy of various yield spreads. Market historians have already echoed the fact that the vaunted 10 year minus 2-year yield curve inversion (short rates above long rates) often has a lag of more than a year before the Recession clouds begin to rain. The unusual aspect of this cycle is having parts of the yield spread spectrum inverting while other parts are expanding rapidly. What may be the more salient factor in this dichotomy of yield spreads is the unusual monetary over stimulation that triggered supply chain inflation and the dislocation of debt maturities bought by the Fed. The extreme intervention of the Federal Reserve, owning 30% of all Mortgages and dominating US Government Treasury debt market, has skewed the free-market ownership distribution of various debt maturities. If the Fed buys fewer 2-year Notes in favor of more 3 Month instruments, then they can artificially alter the curve and its historical relationship with the economy. The fact is, the economy is not slowing yet from rising rates, but is decelerating from artificially unsustainable stimulus levels that have choked up the supply chain. This created a wider gap in demand over supply, which causes inflation. Unfortunately, the Fed has very few tools and they are all focused upon demand through the artificial movement of borrowing rates and loanable reserves. The problem is supply. A lack of material and labor prevents homes, cars and all types of finished goods from being produced to meet demand. Thus, even though demand increases, the economy can actually slow down as a result of lengthening supply chain delays. The Fed can’t increase supply to meet demand, so their plan is to keep draining bank reserves for lending and ratcheting up borrowing costs with rate hikes until consumption slows and a Recession is on our doorstep. As always, the question is, can the Fed pilot this economy into a soft landing without a hard Recession? History is not on their side and the Russia factor is an added wrinkle. However, we can be certain that as soon as PCE inflation is within reach of their long-term targets near 3%, then the Fed will begin talking about easy money once again to keep the economy above stall speed.

The history of diverging yield curves is brief, but it appears to be a Bullish signal for stocks when the 10 Year Treasury yield is expanding its spread with the 3 Month yield. The 10 Year yield has been exploding higher recently as the market increasingly forecasts a more rapid rate hiking cycle by the Fed. With the 10 Year jumping from 1.7% to 2.7% in just the past month, it’s very likely a pause in market yields is due while we await the consensus 50 basis point hike at the next FOMC meeting on May 3rd. Should the 10 Year march higher to test 3% before this meeting, it’s possible stocks would actually rally short term in the face of this extremely rapid credit tightening, if recent history is our guide. It will be instructive to monitor the 10 Year to 3 Month spread during this period of rapidly rising rates. For now, this relationship is Bullish for stocks.

 

 

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