Inverted Yield Curve Hysteria

Investors naturally seek tea leaves that foretell the future. Over the past 2 decades it has become increasingly well known that every Recession is preceded by an inverted yield curve, where short term interest rates rise above longer-term maturities. Since stock investors anticipate these inversions and subsequent Recessions, we find more prognosticators start ringing alarm bells long before an inversion occurs. When investors assume they have a crystal ball, they tend to self-sabotage by over anticipating an event and altering its expected outcome. On the far-right side of the chart below, it’s evident that the widely followed 10 Year minus 2 Year Treasury Yield spread (blue line) has narrowed precipitously close to the dreaded inversion line. However, what’s unique this time is that other yield curves have actually widened and moved far away from triggering a Recession countdown. Every economic and accompanying stock market earnings Recession occured within months of the 10 Year minus 3 Month spread inverting as well as the 10 Year minus the Federal Funds Rate Yield. We have no doubt that these spreads will narrow as the year progresses, but it’s clearly premature to worry about overly tight credit conditions implied by an inverted yield curve. In fact, it can be argued that key parts of the yield curve have been Bullishly upward sloping (green and red lines below). Should all of these Yield spreads invert someday with  short term rates exceeding long term yields, there is typically another 4 to 18 months before an actual Recession kicks in.

During the past 2 years of Covid mandates and pandemic related fears, Consumer Sentiment has plunged to levels that have always been coincident with an ongoing economic Recession and Bear market in stocks. However, like the yield curve chart above, this cycle has been unique. Normally investor optimism and a rapidly growing job market are accompanied by rising consumer sentiment. While investor sentiment has soured with the market correction this year, the extremely strong job market and backlog of consumption demand implies that the consumer is worried about inflation, Covid restrictions and the war, yet they are still spending and benefiting from rapidly rising wages. If we are correct, then sentiment should work higher once the pandemic fades and inflation rolls over. The Ukrainian War is a major wild card that could double food and energy prices within weeks upon a significant war escalation or peace could break out and send wheat and oil prices lower by 20 to 30% within days.

The good news is that the bad news has been so dire that, despite the normal Bull market correction in stocks, fund managers are holding near record allocations of cash that typically presages a strong rally.  The AAII small investor as well as Hedge Fund surveys echo the same cautious sentiment that favors confirmation of a market bottom near the March lows. Some of the War and most of the inflation worries are currently priced into the stock market. 

Since the pandemic struck, the Government and Federal Reserve Bank artificially stimulated demand and suppressed interest rates. Now that fiscal stimulus has ended and monetary tightening has begun, just as inflation is soaring to 40 year highs, Fund Managers have understandably assumed that forward profit forecasts will need to be reduced. They expect slower profit growth this year with valuation multiples of price to earnings that will contract. While it’s premature to expect record highs in stock indices with the uncertainty of the number and size of coming Fed rate hikes as well as unpredictability of War, this is a time to increase equity exposure on price dips while sentiment is historically pessimistic. 

This year’s 2-month correction in the major stock indices of 13% for the SP 500 and 21% in the Nasdaq Composite has been very normal and has only brought stocks back to the area they resided in last October. Some major uncertainties needing clarity for investors are the war, inflation and economic growth that could move equities sharply in either direction. Should the war escalate with a sudden cutoff of Russian fossil fuels and Uranium or the limited use of nuclear weapons, then commodity, cyber security and defense stocks will continue to soar to the detriment of broader indices. If a path to peace begins to emerge, inflation will roll over and these same investment war themes will decline temporarily. Even with a removal of sanctions, wheat crops will not be grown in Ukraine, while Russian oil and gas exports will continue to deteriorate rapidly without Western petroleum companies that have all vacated Russia.

As of March 23rd, all of Seasonal time frames for US stock indices have turned higher until late April. Only a serious escalation of the Ukrainian War or loss of Russian energy exports are likely to trigger a counter Seasonal decline to new lows. 

A closer look at the Daily SP chart indicates the Seasonally weak period we have talked about since January is ended last week and that price resistance for the first leg of a rally is due this week in the 4525 to 4580 window. The Russian invasion of Ukraine adds a significant wild card factor for an exogenous event that could require sudden portfolio shifts. For now, there are signs of a shifting Russian strategy to focus their ground forces and firepower disproportionately upon Eastern Ukraine to secure a land bridge from Russia to the Black Sea. We always felt that expanding their footprint throughout Eastern Ukraine was the primary objective. It should become more evident in April, if or when Putin secures the port city of Mariupol and the Eastern coastline, if he’s ready to claim a pyrrhic victory and pull back from the rest of Ukraine, for which they never had the manpower to hold. While a sudden stoppage of a Russian fossil fuel pipeline or attack on a new country and numerous other possibilities could occur at any time, the severely oversold investor/fund manager sentiment and positive seasonality favors adding equity  risk exposure until proven wrong with a break of 4300 and 4100 basis the SP 500 Index.

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