In meteorology an inversion is a phenomenon where colder air is trapped below warmer air, often caused by clouds trapping the warmer air close to the ground while the upper levels of the atmosphere cool. If you are in an area with hills or mountains and happen to be above the cloud level this can provide a beautiful view of peaks sticking out above the clouds. But from a high vantage point you are unable to see what lies beneath the clouds. You may also have heard about a yield curve inversion, but what does that mean and what does it tell us? What lies beneath the clouds that we cannot see?
The yield curve is a graphical line showing current interest rates for various maturities with rates on the vertical axis and maturities extending out on the horizontal axis. Normally it has a positive slope, with rates moving higher as maturities are longer. An “inversion” occurs when shorter term interest rates are higher than longer term interest rates. This can occur for varying maturities but is most often quoted as the difference in yields (or “spread”) between 2 year and 10 year U.S. Treasury Notes. Interest rates are a measure of future risk so investors would expect to be compensated more, in the form of higher interest rates, for longer maturities since there is increased risk with holding a longer-term investment. An inverted yield curve might indicate that there is just as much, if not more, risk in the shorter term. What risks might this be foretelling?
An inverted yield curve can often, but not always, signal a recession. Historically when an inverted yield curve does signal a recession, it has been anywhere from two to six quarters prior to the recession starting, with the average being about one year. The magnitude and duration of a yield curve inversion are important and can provide an indication of the odds of a recession occurring and if so, how deep and prolonged the recession may be. The yield curve became minimally inverted at various times over the past two weeks but has only remained this way for a few days. This is not enough of a warning signal to say a recession is a certainty. However, with inflation near 7% and short-term rates remaining close to zero we expect the Federal Reserve to raise short-term rates much higher so we could see a much deeper inversion, especially if longer term rates do not follow the same path higher.
Reviewing past events, stocks tend to drop before a recession, but have positive performance during the recession and very strong performance after the recession as the economy recovers. It is important to remember the economy and stock market are not one and the same, with the stock market being a leading indicator and economic data being reported looking back. We do not yet know if we are going to enter a recession but even if we do, there is a chance we have already experienced the corresponding pullback in the stock market. If the current yield curve inversion foreshadows an upcoming recession, it may be several quarters in the future and in the meantime the stock market could perform well.
The first quarter of 2022 is now behind us, so it is worth taking a look back to review what occurred. Most global stock market indices ended the quarter lower, the first quarterly losses since 2020, with the S&P 500 ending the quarter down 5%, the Dow off 4.6% and the Nasdaq losing about 9%. All were even lower a few weeks prior, but the markets surged since the Federal Reserve only raised interest rates by one quarter of a percent at their March meeting. While the major indices reached their low points in early March, many individual stocks reached their low points in late January or mid-February and are continuing to show strength.
The bond market did not do much better with bond prices falling as interest rates rose. The most widely followed bond index, the Bloomberg Barclays Aggregate Bond Index, dropped nearly 6% on the quarter. As we discussed last week, the traditional “60/40” portfolio consisting of 60% equities and 40% fixed income has not fared well, nor do we expect it to for at least the next two years since interest rates are expected to continue to rise. Commodities performed well as prices spiked from concerns about diminished world supplies resulting from the Ukraine situation. Prior to the events in Ukraine, the stock market was already headed lower, which was attributed to stock valuations well above historical norms, especially technology stocks, and anxiety over Federal Reserve action to combat inflation. The Ukraine situation further increased volatility and selling pressure, at least in the short term, but the focus now remains on further Fed action and interest rates.
As we embark on the second quarter of the year, many clouds hang over the market especially inflation and the Ukraine situation. The latter’s effect on the markets is most likely diminishing with markets most likely to be affected by interest rates and inflation. We are also seeing a decrease in consumer sentiment. With higher levels of inflation, especially for food and energy, consumers are less likely to spend money on discretionary items. A major pullback in consumer spending will undoubtedly dampen economic growth so we are keeping a close watch on this and do not expect consumer sentiment to improve until inflationary pressures abate. We also continue to watch the yield curve to determine if the inversion becomes deeper and is truly signaling an impending recession. Even if it is, this does not necessarily mean the stock market is going to drop further.
Every recession is different and caused by varying factors and while we can use history as a guide, it is not a way to predict the future. Whether we end up in a recession or not is somewhat inconsequential to investors since the stock market, while effected by the economy, moves independently. If you are worried about what is beneath the clouds that you cannot see and how it may impact your retirement, please give us a call to ensure you have a solid plan in place to weather whatever lies ahead.
Have a great week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
Please contact us if you would like to review your individual financial plan or learn how the TaxSmart™ Retirement Program can help you.
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