Inverted Yield Curve Signals Recession
Key Points – Inverted Yield Curve Signals Recession
- Jerome Powell Gives Optimistic Outlook Ahead of December FOMC Meeting
- More Stocks in Bullish Territory
- A Steep Inverted Yield Curve Is a Primary Indicator of a Recession
- Remaining Patient Continues to Be Pivotal as We Wrap Up 2022
- 5 Minutes to Read | 8 Minutes to Watch
Why Does an Inverted Yield Curve Serve as an Indicator of a Recession?
Along with looking at the latest trends in the stock and bond markets, Dean Barber discusses why the inverted yield curve is a signal of a recession in the November 2022 Monthly Economic Update.
Could the Hiking of Interest Rates Finally Start to Slow?
Hi everybody. I’m Dean Barber, founder and CEO of Modern Wealth Management. Welcome to the Monthly Economic Update. On November 30, Jerome Powell announced that he thought that a slowing in the rate of interest rate increases could start as early as December. We will find out on December 14 whether he stays true to his word.
What’s Going on in the Stock Market?
As you know, the interest rate hikes due to runaway inflation have been the bane of existence for both the stock and the bond market this year. We’ve seen a little bit of a reprieve here in November. Some of our signals are pointing to more bullish short-term things happening.
FIGURE 1 – November Stock Market Performances – Chaikin Analytics
In recent Monthly Economic Updates, I’ve been showing what indices are in very bullish, bullish, or neutral territory. In Figure 1, you’ll see that we do have more of the major indices in bullish territory, such as the Russell 2000, the S&P 600 Smallcap, S&P 400 Midcap, and the RSP equal weight. The Dow Jones Industrial Average is very bullish.
There are far more stocks that are currently considered bullish than what we saw two or three months ago. The RSP equal weight was our best performer over the course of last month, up 4.13%. The worst performer over the last month was the Russell 2000, down by 0.52%.
FIGURE 2 – Year-to-Date Stock Market Performances – Chaikin Analytics
Why Interest Rate Increases Have Impacted the Technology Sector the Most
When we look at this on a year-to-date basis in Figure 2, it’s evident that the pain has been fairly widespread. Worst of all is the NASDAQ. That purple line is the QQQ, which is an ETF that tracks the NASDAQ. The reason why the technology sector has suffered so much more than the others is because the technology companies are the ones that are the most highly leveraged.
The more leverage that these companies have, the more expensive their debt becomes. And that hurts their profitability. It stands to reason that the rapid increase in interest rates is hurting our technology stocks far more than others. The Dow Jones Industrial Average is much heavier in energy and health care and finances. It’s doing the best because those are simply staples.
And then you have everything in between. The S&P 500 is off by almost 17% on a year-to-date basis. The best performer year-to-date is the Dow Jones Industrial Average, down by 6.84%.
Is a Santa Claus Rally in Store?
Whether we wind up with a little bit lower numbers than these by the end of the year or if we make a few percent over the course of the next month with a Santa Claus rally, that remains to be seen. I believe that the decision that the Federal Reserve makes on December 14 will tell a lot about how the final two weeks of the year is going to go.
As of the afternoon of November 30, the Dow rallied a little over 400 points following the speech of Jerome Powell. He believes that he can start slowing the pace of rate hikes as early as the December FOMC meeting.
FIGURE 3 – The U.S. Treasury Yield Curve – ustreasuryyieldcurve.com
Let’s look at the treasury yield curve. This is something that we haven’t seen since the early 1970s. I’ve been showing you this yield curve now for the last few months. I’ve explained that when we have short-term yields like with the one-year treasury currently yielding 4.78% and the 10-year treasury yielding just 3.75%.
We have a full 1% spread between the one-year and the 10-year treasury. The last time that happened was the early 1970s. From 1969 to 1979, we had bull and bear markets following each other for a decade. At the end of 1979, we were exactly where we were in 1969. That was referred to as the lost decade.
Is There a Recession Ahead in 2023?
We also had a lost decade from 2000 through 2010. There was virtually zero growth, but a ton of volatility. Any time you get an inverted yield curve this steep, a recession tends to follow. It’s almost impossible to say that with our current inverted yield curve that we’re not going to go into a recession next year.
That being said, most of the wise economists think that the pain in the markets and economy should finish through that by the end of Q2 next year. As I said earlier, the day that Jerome Powell says that the Fed is done raising rates and inflation under control—even if the economy is in a recession at that point—will mark the beginning of a very large and sustained rally in the broader markets.
I think that this year could have turned out worse. At one point, the S&P 500 was down as much as 25%. The NASDAQ was down as much as 35%. Bonds were down as much as 17%. Let’s look at what’s going on with bonds year-to-date in Figure 4.
FIGURE 4 – Bonds Year-to-Date – Kwanti
Atypical Behavior of Bonds in 2022
This is an ETF called AGG, which tracks the U.S. bond aggregate. For most of the year, it has been declining. We had a little bit of a reprieve in July, but there was more pain after that. At its low, the bond aggregate was negative by 16.6% on October 24.
At that point, the markets were off about 25%. But there have been a few times this year where we’ve seen a similar loss in the S&P 500 as we’ve seen in bonds. Typically, we expect the bond component of the portfolio to be the ballast. It’s usually what keeps the portfolio up when markets are falling.
But bonds have not provided that ballast this year. There is a silver lining with the bonds, though. I believe that you start to see a rally in bonds on the day that the Fed says, “We can stop raising rates.” You’ve already started to see that rally in bonds off their lows. They’re up about 5% in the last month and a half or so.
Remain Patient Through This Bear Market
We need to continue to have patience. At the end of every bear market, there is a bull market that follows. We’ve made major changes to portfolios throughout the course of the year to try to protect as much as possible. And we continue to monitor everything daily to look for opportunities that may exist.
The most important thing that you can do if you’re a client of Modern Wealth Management is to keep the lines of communication open with your financial advisor. Let them know what questions you have. We’re here to help you. We’re here to make sure that you don’t make emotional decisions and that you can achieve your overall financial objectives.
I hope all of you had a very wonderful Thanksgiving and got to spend some time with family. As we enter the holiday season, I wish all of you a very safe and happy holiday season. If you found this information useful, please share this with your friends.
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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.