Nature abhors a vacuum.
This quarter’s Synthetic Systems update came with a disclaimer … but that doesn’t mean Financology is bereft of opinion on the outlook for stocks, bonds, and commodities. So let’s roll up our sleeves and fill the void.
The underpinning for this view is the yield curve. Not that SS doesn’t take the curve into account, but for whatever reasons either found other factors more compelling or found in it different timing conclusions.
Normally an inversion of the curve does not mean imminent recession, where for our purposes the “recession” of concern is in the financial markets. Let’s take a look at the last major cycle as an example. The Fed started hiking the Fed funds rate (from an emergency accommodation level of 1%) in 2004. The yield curve inverted in 2006. The recession came in 2008. A more minor cycle occurred in 2020. There the yield curve inverted in 2019, the recession came in 2020.
As we’ve pointed out a number of times, inversion->recession is overly simplistic.
It’s more like inversion->uninversion->recession.
Indeed, by the time the 2020 recession arrived, the yield curve inversion of 2019 had been all but forgotten in the financial media. Even before the coronavirus story sucked all the oxygen out of the room. It was like the yield curve is no longer inverted, so the recession signal is voided. No … it was worse than that … it was if the inversion had never happened.
It doesn’t work that way. The implications of a yield curve inversion don’t vanish with the inversion. It’s practically necessary for the curve to uninvert before the recessionary implications unfold. In the 2008 cycle, the Fed had actually begun to cut short rates in September 2007, the month before the stock averages even peaked. It cut rates all the way through the ensuing bear market, eventually even resorting to quantitative easing when they reached zero.
This cycle, the yield curve inverted in 2022. Stock prices fell, but recovered even as the curve remained inverted into 2023. It still remains inverted. Financial media are now declaring the recession has been cancelled.
That just feels so late 2007 and late 2019. Because the inversion has not been immediately followed by recession, media are hailing it as an all clear. Veteran Financology readers can already guess we are not persuaded. If anything, because of the extraordinary depth and length of this inversion of the curve, it’s quite the opposite. It’s like before a tsunami, when the sea first pulls back, luring its unwitting victims closer before unleashing its full fury.
The market implications are similar. The recession has not been cancelled. The sea is pulling further back, coiling for the flood ahead.
The completion of the bear market in stocks SS had pencilled in for this year is still out there. The bull market in bonds is still pending. We don’t know just when, but short rates will begin to fall and the yield curve uninvert before the bulk of it unfolds.
Commodity prices are likely to decline as well. Gold could be among the first to recover, as markets see inflation in falling rates and monetary easing. Other commodities, such as copper and energy, may take longer to recover but could rise much more. $200 oil is not at all out of the question, even higher due to premature politically driven underinvestment colliding with a clean energy reality that takes longer to build.
So what specifically to look for? The yield curve is just that … a whole curve, not merely a pair of points on the curve. We can look at any pair of them, thirty years versus three months, five years versus six months … if I had to choose just one it would be ten years versus one year. When the one year yield falls below the ten year yield we’ll say “the yield curve” has uninverted. For short rates per se we can look to the one year as well. We won’t try to deconstruct Fed rhetoric for this purpose though … any rate information worth taking to the bank can be found in the Treasury yield curve.