Breaking the Cycle

The Federal Reserve is trying to break the cycle of rising prices without breaking the economic cycle. History suggests this is not an easy task with the Fed’s response to inflationary pressures in the late 1970s and early 1980s leading to a hard landing for the U.S. economy (see figures 1 and 2). It is these worries that led to the 2-year U.S. Treasury yield rising above the 10-year U.S. Treasury yield – also known as an inversion of the 2s10s yield curve.

This line chart shows the U.S. Consumer Price Index percent versus the Periods of U.S. Recession from 1955 to 2022 year-to-date.

This line chart shows the Effective Federal Funds Rate percent versus the Periods of U.S. Recession from 1955 to 2022 year-to-date.

The reason an inverted yield curve is a big deal is because it is often considered to be a leading economic indicator of a potential U.S. recession. In fact, every U.S. recession in the past 60 years has been preceded by an inverted yield curve. There was just one instance where an inverted yield curve was not followed by a U.S. recession, in the mid-1960s, when the Fed was able to pull off one of its soft landings. The general rule of thumb is that a U.S. recession is likely within the next two years with a range of about six months to 24 months (see figure 3).

Of course, every time the yield curve inverts investors debate whether it is a false signal. Those in the false signal camp argue that the Fed’s bond buying program, or quantitative easing, has pushed down the 10-year U.S. Treasury yield and when the Fed stops buying bonds the 10-year U.S. Treasury yield will rise and the curve will steepen. Others argue that the 2s10s curve is the wrong curve to watch and that investors should be watching the spread between the 3-month T-bill and the 10-year U.S. Treasury yield, which is nowhere near inversion. That’s is certainly true, but it is largely because the spread between the 2s10s curve is reflecting what investors expect the Fed to do and the 3Mo10s curve is reflecting what the Fed has done thus far. It makes sense that they are currently showing two different outcomes given that the Fed has just begin its monetary policy tightening cycles. The primary takeaway from the difference between the two yield curves is not that one is wrong and one is right, but that the future is not yet written.

This line chart shows the 2s10s Yield Curve Percent verses Periods of U.S. Recession from 1977 to 2022 year-to-date. The 2s10s curve tends to invert about 15 months prior to the onset of recession.

Currently, the two-year U.S. Treasury yield is pricing in the equivalent of about 10 rate hikes. If we look at the futures market, it is pricing in eight rate hikes with a 50 basis-point rate hike likely in May and about a 62% chance of 9 rate hikes, which presumably means back-to-back 50 basis-point rate hikes in May and June (see figure 4 and 5). This is consistent with Fed Chair Powell saying, “Nothing,” was keeping the Fed from raising rates by 50-basis-points.

This line chart shows the two year U.S. Treasury Yield in percent versus the Federal Funds Rate from 2012 to 2022 year-to-date.

This line chart shows the Number of Fed Rate Hikes Expected by the End of 2022, beginning June 2021. The market is still pricing 8-9, equivalent to 25bps, in Rate Hikes by Year End.

Importantly, the Fed could still change its mind. If inflation gradually falls, then the Fed may decide to slow down its tightening cycle, which would significantly raise the odds of an economic “soft landing.” However, as it stands now, it appears to us that the Fed is intent on tightening policy until inflation comes down sharply. Only time will tell whether the Fed will succeed in its stated goal of, “The economy achieves a soft landing, with inflation coming down, and unemployment holding steady.”

What Does an Inverted Curve Mean for U.S. Stocks?

Surprisingly, very little in the near-term. During the last five U.S. recessions, the S&P 500 did not peak until about four months prior to the onset of recession (see figure 6). The weakest lead time was in February 2020 when policymakers engineered a recession with lockdowns in order to limit the spread of COVID-19. However, during more traditional recessions the market peaked as far ahead as eight months and as little as two months ahead. The primary reason this occurs is that corporate earnings often continue to rise as the economic cycle transitions into its later stages. For example, even in the face of a potential recession down the road, S&P 500 earnings-per-share (EPS) are still projected to climb by 10.3% in 2022. We think this argues against exiting the equity market altogether. We prefer a more defensive, diversified portfolio that focuses on quality companies with strong balance sheets and stable earnings (global pharmaceutical companies, consumer staples companies, and dividend growers). Investors may also want to consider potential inflation hedges like natural resources, agriculture, metals, and other commodities. For detailed insights on global fixed income markets and potential opportunities, please see our CIO Strategy Bulletin | A Brighter Future for Fixed Income?

What Should U.S. Investors Watch in the Week Ahead?

We suspect that the release of the March 16th Federal Open Market Committee (FOMC) meeting minutes on Wednesday at 2PM EST will garner most of investors’ attention. It is widely anticipated that the minutes will include details on plans to bring down the Fed’s balance sheet. The minutes may also discuss the Fed’s feelings on 50-basis-point rate hikes at upcoming meetings. Citi Research’s economists believe that the roll off will begin with $15 billion per month of Treasuries and $10 billion per month of mortgage-backed securities. Eventually that pace will likely be scaled up to $45 billion per month in Treasuries and $30 billion in mortgage-backed securities. There will also be a slew of Fed speakers this week that could make headlines with Brainard, Daly, Williams, Harker, Bullard, Bostic, and Evans each making comments.

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