Yield Curve Inversion Puts Bull Markets At Risk


Back in August of 2018, we wrote a perspective piece entitled “The Trending Fed.” We concluded that “trending markets and economies are not held hostage to time limits. Picking tops and recession forecasting is often a recipe for failure. However, the first rate cut by the Fed will likely NOT be the last, and it has historically indicated that the trend in the economy and earnings has changed. In this context, rate cuts by the Fed are NOT bullish for risk assets. I will continue to follow 2Y-3M steepness for signs that a trend change is imminent. If inversion is accompanied by weaker labor markets, my bullishness for the U.S. economy and risk assets will quickly wane. But right now, none of these signals are flashing red.” We included a few charts to illustrate.


The S&P 500 is within 5% of its all-time high. The Fed has tabled its rate-hikes for 2019 and it is their intent to remove Quantitative Tightening (QT) by the Fall. The “all clear” button has been pushed, has it not? Not so fast. As much as the equity markets salivate over a dovish Fed, history has shown that easy monetary policy often follows deteriorating fundamentals, and that a couple of rate-cuts do little for asset prices as earnings expectations catch down to reality. Not to mention, a change in earnings trend is almost always accompanied with multiple compression as margin calls and fear generally cause markets to overshoot fair value.

What has changed since August? Well, remember the 3 month – 2 Year portion of the yield curve I mentioned? It’s inverted. We place great importance on this indicator. It represents the difference between current Fed policy and where the bond market projects Fed policy to be over the next couple of years. An inversion signifies that the current hiking cycle is likely over, and that we may be entering an easing regime. I advise those waiting for a 2-10 inversion to be wary. Central Banks have distorted the term premia associated with longer-term bonds, and as a result, this portion of the curve may NOT invert prior to the next recession. Sure, it very well could, but remember, Japan has experienced multiple recessions without 2-10 inversion.

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Disclosure: This article is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. ...

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