Yield Curve: What Is It Telling US?

The Yield Curve Inverts

What are the economic and market implications?

In March, the real action had been in the bond markets with US Treasury bonds registering their worst quarter since 1973. Treasury bonds actually underperformed the S&P 500 for the quarter. There has been a rapid repricing of yields year-to-date with US 2-year Treasury yields rising +174 basis points, even faster than 10-year US Treasury yields climbing by +82 basis points. Hence, the yield curve has inverted on several maturities. (Chart 1) In particular, the shorter end of the curve with the 2-year Treasury yields at 2.4% reflects the market pricing of eight more hikes this year. 

In addition, other curves like the 10 year–3 month are actually steepening. Keep in mind, the 3-month yield is anchored by the fact we have only had one Federal Reserve rate hike, but nonetheless it normally would more correlate with the other curves.

What has driven these yield moves? The rapid economic recovery triggering continued supply chain inflation, rising wage inflation, and  commodity price inflation. The Ukraine War has further exacerbated this situation in particular, in Europe.

How useful is the Yield Curve as an Indicator: Long Lead and Lag Times

The problem with basing all your asset allocation on the yield curve are the lags. What does history tell us?

Since 1967, across 7 tightening cycles, the S&P 500 peaks anywhere from 2 months before to 20 months after a yield curve inversion of 10 year–2 year yields. On average, the S&P 500 peaks 11 months after the curve inversion with on average a 15% return.  The returns vary between -4% again in 1973 and +34%. Therefore, on AVERAGE, there is upside in equities after inversion.

With regards to recession, on average, a recession begins 5 months after the S&P 500 peaks. Hence, if we combine the time that on average the S&P peaks 11 months after and a recession 5 months after that, for a combination of 16 months after inversion.

While we have made downgrades to GDP and upgrades to inflation, we do not expect a recession in 2022. Keep in mind the lags on monetary policy as discussed above. 

How Do Equity Markets Perform In Fast Rate Hiking Cycles?

It is interesting to separate the performance of S&P 500 during periods of fast and slow rising rate hike cycles.

Historically, going back to rate hike cycles since WW2, the S&P 500 rises on average 5.3% one year after the first rate hike. However, in slow tightening cycles, the returns are +10.5% and fast tightening cycles -2.7%. At the same time, returns are positive in the second year in slow tightening +1.6% and fast rate rise cycle +4.3%. Of course, this is just one factor driving part of our neutral equity view made before consensus in February.

The global equity market had a bounce-back in March due to the containment of the Ukraine War. At the same time, we upgraded US equities from underweight back to neutral as well as raising US technology which incidentally led the rally and consumer discretionary sectors back to neutral. We felt that the US could rally short-term and indeed that transpired with the S&P closing down at the end of the quarter -4.9% recovering from a year-to-date drawdown of -14%. From here on, we expect a more range-bound environment in the S&P 500 and most global equity markets, pending the situation in Ukraine, the extent of inflation and the upcoming tightening from the Federal Reserve.

Important Factors to Monitor:

• Rates are forecasted to rise faster than “normal” rate hiking cycles. We expect a 50bps rate hike in May rather than 25bps. We thus expect an additional 150bps of rate hikes this year. As the Fed frontload its hikes, we now anticipate 75bps next year rather than 100bps. Our 2023 Fed funds target remains at 2.75%.
• Rate hikes do not help supply chain inflation.
• There are parallels and differences with the 1970s, when the S&P 500 peaked two months before the 10Y – 2Y yield curve inversion.
• How much has quantitative easing distorted the yield curve by capping longer dated yields? Could the curve steepen as quantitative tightening begins?

In that regard, it was interesting the yield curve flattened into the upcoming quantitative tightening, when normally it steepens.

Upgrading Government Bonds To Neutral For The First Time In 9 Years After Global Bond Carnage

After the increase in Treasury yields and German yields we turn neutral on developed market government bonds. This is the first time in 9 years. There are finally some emerging alternatives to cash, as we favour US short-term government bonds within the overall neutral view.

Additionally, we increase our 10-year yields targets to 2.50% in the US and 0.75% in Germany in one year. We expect balance sheet reduction to be announced / start in May rather than July. The ECB could taper its QE in Q3 and hike rates in December. 

CONCLUSION / STRATEGY:

• The yield curve normally inverts on average well before equity market peak; recessions has large lead and lags making its sole use for equity and bond decisions asset allocation not completely useful.
• We remain neutral global equities taking a non-consensus view to downgrade back in February. We have subsequently upgraded US equities from underweight back to neutral in March after it entered correction territory.
• For the first time in 9 years, we turn neutral on developed market government bonds. There are finally some emerging alternatives to cash, as we favour US short-term government bonds within the overall neutral view.
• In addition, we increase our 10-year yields targets by 25bps to 2.50% in the US and 0.75% in Germany in one year. We expect the balance sheet reduction to be announced and start in May rather than July.