From the desk of Steven Strazza @Sstrazza and Ian Culley @Ianculley
It finally happened…
The yield curve inverted for a brief moment as the 2-year yield rose above the 10-year earlier this week.
But whether or not it inverted yet is beside the point. It’s been flattening for a long time, and that’s the direction we’re headed in. It's only a matter of time.
While media outlets and fearmongers will spin this development as an urgent warning of an impending bear market, here's what you need to know: Throughout history, equities have done well during and after inversions.
This commonly observed leading indicator has a tendency to precede major market tops by years, not months. In other words, there's still time. The average lead time is about 18 months after prior inversions.
More importantly, when it comes to forecasting bear markets and recessions, many experts will argue that it is actually not the 2-year we should be focused on, but the 3-month yield.
And when we do this, the outlook is the exact opposite of what the 2s/10s spread is currently portraying.
Let’s take a look!
Here’s an overlay chart of the 2s/10s spread and the 10-year minus the 3-month spread:
Talk about a divergence!
Notice how closely these two spreads followed each other until last fall. It was then that the Fed changed its “transitory” stance on inflationary pressures, admitting that a period of tightening was necessary.
Immediately, the bond market started pricing in the fact that the fed had fallen behind. And that’s where these sections of the curve diverge…
While the 2-year is a reflection of what the market expects the Fed to do, the 3-month is a reflection of what the Fed has already done.
While the 2s/10s spread is the traditional section of the curve that gets the most attention, we’re just as concerned with what the Fed has done as what the market expects it to do.
For that reason, we want to weigh the 3-month spread just as much if not more than the 2s/10s.
The difference between the 10-year and 3-month yield has widened to its highest level in years. Unlike the spread between the 10-year and 2-year, it’s not contracting, and it’s certainly not inverting.
While the 2s/10s sends a cautionary message, the information we’re getting from the 3-month spread is the polar opposite. Everything is fine. Business as usual.
Before we entertain the idea of an end to the current cycle, we want to see the 3-month rate surpass the 10-year and confirm what we’re seeing from 2s/10s.
At the very least, we’d want it to be heading lower. Today, we’re not even close as the spread is making new highs.
If and when it does invert, we’ll be sure to let you know. Until then, we think a lot of this yield curve fuss is overblown.
Thanks for reading.
Countdown to FOMC
Following the Federal Reserve's recent rate hike, the market is pricing in a 50-basis-point hike at the May meeting.
Here are the target rate probabilities based on fed funds futures:
