It's Saturday night as I write this post. The suitcases are packed, boys are in bed, and we're off to Bondi tomorrow morning for the school holidays - family road trip in the Tesla. This will be the longest we've travelled in the EV and I'm really looking forward to it. We did a trip to Falls Creek not that long ago and it worked like a dream. I'll be skipping next week's note as I spend time with my wife and boys.
Let's get onto this week's note on markets.
Financial markets have been breaking many records of late. Why stop now? We are more or less at the end of the rate hiking cycle, and it's been almost eleven months since the US Treasury yield curve first inverted. It's been inverted for 210 trading days and isn't showing any signs of moving into positive territory anytime soon (see chart below - all courtesy of Bespoke). The current streak of 210 trading days ranks as the longest streak of days with an inverted yield curve since at least 1962.
Looking back in history, there are only two other periods in the last 50+ years that the yield curve was inverted for more than 200 trading days. The first (207 trading days) was leading up to and during the first dip on the 'double-dip' recession of the early 1980s, and the second was the 209 trading-day streak that ended in May 2007 just over six months before the recession that began in late 2007.
There have only been a handful of other periods since 1962 that it has been more inverted, and on a percentile basis, the current level is in just the 3rd percentile relative to all other readings. So not only has the yield curve been inverted for a record amount of time, but there are also very few other times in history when it has been inverted by more than it is now. This is the same yield curve that the New York Federal Reserve refers to as the indicator which “significantly outperforms other financial and macroeconomic indicators in predicting recessions.”
Since inverted yield curves have typically preceded recessions, it should come as no surprise that equity market performance following deep yield curve inversions has historically been weak. In the chart below of the S&P 500, the red lines show all the times that the yield curve was in the tenth percentile or less of its historical readings, and while it wasn’t always the case, most of these readings occurred either leading up to or after a peak in the S&P 500.
Looking at it another way, the bar charts below summarize the performance of the S&P 500 in the year following various levels of the yield curve grouped by decile. Of the ten deciles, the only one where average forward returns over the next year were negative and positive less than half of the time was when the yield curve was in the tenth percentile or less (as it is now). When the yield curve is at these extreme negative levels, the S&P 500’s average one-year return was a decline of 1.29% with positive returns just 46.6% of the time.
That’s not to say that the market must go lower from here. Inverted yield curves precede recessions. And recessions typically don't start until the yield curve is back into positive territory (see chart number three). And given how far and deep we are in the inversion, it may be sometime before the yield curve is in positive territory and a recession follows.
Historically, when central banks pause, they rarely raise rates again. We generally see rates on hold for about 9 months (on average). Over the last four rate hike/pause cycles, 2006 was the longest at 12 months with rates being cut soon after. Furthermore, we generally don't see credit spreads blow out until about 24 months following peaks in central rates. Maybe I'm clutching for straws here, and the market will prove me wrong at any time, but I think this plateau period, before shit really hits the fan, might be around for a little longer than we think. This doesn't mean the stock market won't react sooner. Asset allocation has never been more important.