The fundamental factors are slow-moving. They are so important that they practically rule the eventual trend of stock prices but, because they generally change slowly and act slowly, their effect upon prices is more in consonance with long-term movements than with the intermediate swings.
- Richard W. Schabacker, 1933, Editor of Forbes
Market conditions have changed since my last update. Our short-term, intermediate-term, and long-term volatility signals flipped firmly red earlier this week so we are remaining patient and in a cautious posture until we see signs of stabilization.
The Treasury yield curve appears to be all investors are talking about these days. Interest rates are rising across the curve, and investors are keeping a careful watch on it for indicators of an imminent recession. Bond market circumstances have dramatically changed after a decades-long bull run. Bonds are at their lowest point in 25 years, and things could get worse before they get better.
Investors have always viewed Treasuries as a safe haven during times of market turmoil. However, over the last year, they've become a proxy for the upcoming Fed tightening cycle. Stocks and bonds have dropped together. Because of strong inflation and Fed predictions, yields have risen. This has overturned traditional intermarket connections, making this one of the most difficult markets I have ever seen.
The 10Y/2Y Treasury yield spread is closely watched by investors since it is regarded as a recession indicator. The U.S. yield curve has inverted before every recession since 1955, with a recession following between 6-24 months. Has it inverted this year? Yes, technically, it has but for a record short period of time.
To signal a recession, this figure must remain negative for several days, if not weeks. The 10Y/2Y spread went negative for a few days before becoming positive again this time, thus this may or may not be a reliable warning. However, things appear to be moving in that direction. The Federal Reserve aims to raise the Fed Funds rate to 3%. Mortgage rates have surpassed 5%, and the housing market is already weakening. Both real retail sales and real wage growth are falling short of expectations, indicating that people are falling behind and spending less. Furthermore, there is a war in Ukraine, which has caused energy and grain prices to skyrocket.
While the markets expect interest rates to continue to rise as the Fed acts aggressively, I think yields are at or near their peak. I believe it is more likely than not.
When it comes to how interest rates affect bond prices, there are three cardinal rules:
When interest rates rise—bond prices generally fall.
When interest rates fall—bond prices generally rise.
Every bond carries interest rate risk.
Let's start with a look at where interest rates are right now to set the stage.
To recap, the 2-year yield moves in lockstep with central bank activities. Short-term yields tend to climb when the market expects the Fed to boost interest rates. We knew the Fed was going to keep the target rate at 0% in the first half of 2021. As a result, the 2-year yield ranged between 0.15 percent and 0.20 percent. During the fourth quarter, we sensed that the era of easy money was coming to an end, and rates began to rise. The Fed announced a tightening cycle in December, and short-term rates began to soar astronomical, a trend that has only intensified as inflation runs out of control.
The 10-year yield is usually a reflection of the state of the economy. Long-term yields have opportunity to rise if the economy is forecasted to continue growing. When the curve inverts, it usually means that people's faith in the economy is eroding. You might think of it this way: if the 10-year is below the 2-year, it suggests that investors are expecting the Fed to decrease rates, which happens frequently during economic downturns.
The 10Y/2Y spread briefly became negative at the start of April, but it has since firmly turned positive. Long-term rates have continued to rise, while short-term yields have fallen slightly. Does this imply that investors believe the likelihood of a recession is lower now than it was two weeks ago? Perhaps, but the answer to that question has far-reaching ramifications for where rates might go next.
There is a case to be made that yields will rise or fall in the second half of 2022. Let's take a look at the expected scenario for each.
The Case for Why Yields Have Reached Their Peak
The present U.S. economic outlook successfully supports the argument for interest rates reaching a high around this level and then falling. Looking at current conditions, I believe the majority, if not all, current developments or catalysts support the concept that Treasury yields will continue to fall rather than rise.
Most people consider GDP to be a measure of economic growth, yet it is only one figure. Retail sales are one of my favorite indicators of consumer behavior. Right now, the results don't appear to be promising.
The headline retail sales number for March was up 0.5 percent from the previous month. That sounds great, but keep in mind that those values are nominal and have not been adjusted for inflation. Sales were down 0.7 percent in actual terms. But there's more bad news to come. Consider that the previous month's figure includes an 8.9% increase in gas prices. When you subtract that number, the nominal sales rise of 0.5 percent becomes a 0.3 percent drop. When fuel costs are factored out, retail sales were down more than 1% in actual terms.
Inflation is truly slaying the dragon here. We've been waiting for rising food and energy prices to eat into discretionary spending budgets, and now it's here. Expect this to continue to go in the wrong way if inflation continues to roar.
The decline in housing will be another major driver. In January 2021, 30-year mortgage rates reached a low of roughly 2.65 percent. Currently, the going rate is 5.15 percent. Mortgage demand has been impacted by rising borrowing costs, as expected.
Lumber prices are also confirming this. They've dropped about 40% since their peak a little over a month ago. A drop in the housing market has been linked to nearly every recession in recent history, and we're on our way there again.
And don't forget that, despite all of this, the Fed is about to embark on one of its most aggressive rate hike cycles ever.
Is there room for rates to rise further? Yes, of course. For months, the market has been pricing in more aggressive Fed action, mostly due to rising inflation rates and the Russia/Ukraine war. The 2-year Treasury yield was 0.20 percent a year ago. It's currently around 2.45 percent. 9 rate hikes are already being factored in by short-term Treasuries. The Fed wants to get the Fed Funds rate (FFR) to 3%, so we could see another 50-75 basis points of upside in the next two years. However, take another look at the first yield chart.
This week, the yield on the 2-year Treasury note fell. I suspect the trigger was this week's CPI report, in which the core inflation rate came in slightly below forecasts and prompted a flurry of "inflation has peaked" headlines. Let's imagine we discover that inflation rates are indeed declining over the next month or two. That provides the Fed ammunition to be less aggressive, possibly not pushing the FFR all the way to 3%. If this occurs, it's easy to see yields falling again. Short-term rates could fall as a result of the Fed's easing, while long-term yields could fall as a result of the increased likelihood of a recession.
Treasury yields will eventually stop reacting exclusively to what the Fed does and resume behaving like a safe haven asset. I predict that the time will come sooner rather than later.
The Case For Why Yields Will Continue to Rise
This is the "Fed pulls a rabbit out of a hat" scenario, to put it directly. If rates continue to rise, the market expects that the Fed will be able to land the plane and restore normalcy without sending the US economy back into recession. You can probably tell by the manner I'm writing this that I'm not optimistic about this happening. As I've already stated, the Fed should have started raising interest rates and tightening conditions more than a year ago. It was near the end of 2020, when the economy began to reopen. It was at this point that it became evident that the economy was on the rebound, even if it would take some time to get back to pre-pandemic levels. When the economy is thriving and can sustain higher interest rates, it is time to tighten.
Instead, this Fed continued to kick the can down the road, citing low inflation as justification. Inflation is now skyrocketing, and the present economic cycle has passed its apex. Now the Fed will be compelled to tighten in the face of a weakening economy, which I don't believe has ever been done before.
To be clear, it's possible that GDP growth does not actually become negative. The Fed recently lowered its prediction for 2022, but it still expects a 2.8 percent gain for the entire calendar year. According to the Philadelphia Fed's recent survey of financial professionals, growth is expected to be 2.7 percent in 2023 and 2.3 percent in 2024. Because the Fed has a lengthy history of being wrong, I highly advise you to take these figures with a grain of salt.
It's not so much that these numbers are favorable that interests me, but how positive they are. A multi-year growth rate of 2% to 3% would be considered a strong economy. That isn't even close to the levels seen during a recession. These projections are likely to be revised downward again in the future, but these findings show that there is still some breathing room before a recession occurs.
As I stated at the opening, I believe interest rates are approaching a peak. I don't believe the Fed will be able to reach close to its 3% target for the Fed Funds rate, especially if the war in Ukraine continues indefinitely. We're already witnessing signals of economic weakness, and I believe the Fed will make a dovish pivot before getting to where it desires to be.
Rates will move lower once the market detects this, and I believe it will happen sooner rather than later.
The Final Domino To Fall
The next phase of the bond market crash is likely going to be where credit spreads start to aggressively widen. They are already on the move. This will be bullish for bonds and bearish for stocks.
And remember – the one fact pertaining to all conditions is that they will change.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President