June 28, 2023
Good morning,
With apologies, it appears I may have jumped the gun on the summer doldrum call on Monday. Yesterday’s economic data (Consumer Confidence and New Home Sales) was surprisingly strong and reflected both better present business conditions and improved consumer expectations. Yesterday morning’s data surprises led to immediate risk-on buy orders in the best risk-on group of the year thus far – technology. As the trading day wore on, technology’s leadership also dragged the broader market up. On the day, the NASDAQ Composite Index (a loose technology index proxy) was up +1.65% and the S&P 500 Index was up +1.15%. Not a sleepy day at all, but it was just one day.
Futures are soft this morning, off about 25 basis points – twice that for NASDAQ futures which is the norm.
Following the May FOMC meeting, and the last (not necessarily final) Fed rate hike, when the Fed hinted that they may go into “pause” mode, bond market strategists called for the end of yield curve inversion (short term rates higher than long term rates). At that time, the traditional measure of curve shape (2yr yield vs. 10yr yield) was approximately negative 50 basis points (-50 bps = -.5%). Yield curve inversion is a non-normal condition. We all know that almost intuitively, understanding the time value of money. Inversions do not normally last long. But inversions are a highly reliable sign of economic recession. It consistently signals negative economic growth ahead; it is horrible at signaling when.
Today, almost two months later, strategists appear dead wrong (or way early) and the yield curve is twice as negatively inverted as it was on May 3rd – over -100 bps. What gives? Investors are conceding that the Fed is now intensely focused on fighting inflation and less concerned about higher interest rates breaking the US economy. There have only been two periods of longer inversions than today’s version; 1978 and 1980, both part of then-Fed Chair Volcker’s aggressive fight against rampant inflation. If the current inversion lasts through Q12024, it will be the longest ever.
Following Volcker after initially betting the surging inflation would prove transitory, Chair Powell is overseeing the biggest tightening of monetary policy in four decades. While policymakers this month paused the hiking schedule, they laid the path for doing more later this year amid inflation that is still more than double their 2% target. A soft landing now appears elusive, and bets have evaporated for the Fed achieving “immaculate disinflation” through a steady tightening of monetary policy. The debate now is when the economy will start contraction.
Perhaps the when question will be for Friday’s Morning Note, but the takeaway today is that a recession can be deferred but not likely denied. And the longer it is deferred, the higher rates will go, the deeper the recession will be.
Be well,
Mike