[ Part 2 of 2 ] The dreaded yield curve and the stock market
Updated: Jan 22
We ended part 1 with the golden question.
"Why is the stock market rallying, even though the yield curve is inverted."
The answer is it doesn't. Across many economic cycles, the stock market responds differently to curve inversion.
Before we jump into this rabbit hole, you must understand the basics of Treasuries Bonds, Federal Fund Rate, and how the Curve is formed. Please read Part 1 if you have not. The Yield Curve is NOT a blackbox data with a genie residing inside that changes the curve based on his whim. Suppose you approach the yield curve with a shortcut mindset of a "Line up, Market up, Line down, Market down" attitude without fully understanding its implication to the economy. In that case, you are sabotaging your growth as a portfolio manager. Respect the Yield Curve.
So, are we on the same page? Are we cool, bruh?
First thing first, we must define what a yield curve inversion is. The "Industry" definition of a yield curve inversion is when the 10Year Treasury Yield (10YY) is lower than the 2 Year Treasury Yield (2YY).
If we were to convert this information to a mathematical formula, Yield Curve inversion is when 10YY - 2YY = <0
This is the chart of 10YY - 2YY. If it crosses below 0, the 10YY is lower than 2YY, hence, an inversion.
The yield curve first inverted on the 1st of April 2022. I was shocked that day because I thought the bond market clowns were screwing around. The inversion reversed, then was reinverted again on the 4th of July, and has remained inverted since. Also, note that on 28 Aug 2019, there was a touch-and-go moment on the zero line. We will come back to this. The 10YY - 2YY is the most frequently used indicator for Yield Curve Inversion. However, the 10YY - 3MY is also monitored by the more delusional folks who think 10YY-2YY is a fake signal. If 10YY is lower than 3MY, the curve is severely inverted, and the market expects extremely short-term risk.
Look at the T5 (21 Aug 2022) and the T0 (18 Jan 2023) Curve. For the T5 curve, 10YY is lower than 2YY but slightly higher than 3MY. The curve is somewhat flat. On the T0 Curve, 10YY is lower than both 2YY and 3MY. The curve is severely inverted. This is the basic of Curve Inversion.
Let's move on to the most important question;
What does the yield curve inversion predict?
If your answer is "stock market crash, "... WRONG ANSWER!!
This is an example of "shortcut analysis." Shame on you! This is skipping two steps! Bad boy! If your answer is "economy contraction and possible recession," ... ALSO WRONG!!
I led you to this trap, didn't I? Concluding a recession from curve inversions is not as severe of a mistake as saying "stock market crash." Still, you skipped one step.
If your answer is "it predicts short-term yield will collapse due to expectation of Federal Reserve cutting rates."
Congratulation! You have my utmost respect. This is the answer.
This is an extract from the Part 1 article.
The Yield Curve is inverted because the bond market expects the short-term yield to collapse, locking in long-term bonds. Why? It is because the bond market expects Federal Reserve to cut rates.
Now, why does the market expect Fed to cut rates? It is because the underlying economic conditions are deteriorating, which MAY OR MAY NOT lead to a recession. But it has deteriorated enough that the bond market expects a pivot.
If you jumped straight to conclude, "Yield Curve Inversion equals recession," you are skipping one step. Sometimes this one step can be the difference between making big fat juicy money or blowing your account.
Let's take a look at the 10YY - 2YY chart again. Here comes the juicy part.
Let's look at the inversion in Aug 2019. There was a "touch and go" inversion in Aug 2019, but why did we not go into recession? Think deeply and hard. This is a trap question.
Answer one: "But Butt.... we did have a recession in 2020. A recession only comes [insert random number] months after the inversion !!!!"
Whoever says that implies that the Bond Market has inside knowledge of covid19 as early as 2019, but the US would rather sabotage their economy by not sounding the alarm? Do you know that even by early 2020, WHO had no idea Covid19 could transmit from Human to Human because China convinced them that it could not? These folks probably believe 9-11 was orchestrated by the US government.
This is the result of a black-box shortcut analysis approach. Covid19 was an exogenous shock that took the world by surprise. It has nothing to do with the Aug 2019 curve inversion. If you somehow avoided the 2020 market crash due to the 2019 curve inversion, that is nothing more than a happy coincidence (for your portfolio). While the misinterpretation of the curve saved your portfolio by accident, it will encourage bad habits of shortcut/black box approach to interpreting macro data, which can lead to bad trading decisions in the future. Answer two:
Note: Answer two assumes you are not high on drugs and you have rejected the answer one's premise " The Yield Curve inverts for a short period, hence no recession." This answer is partially correct, ONLY if you can explain why. Why did the curve inversion only last a few days in 2019, but it is getting increasingly inverted in 2022?
10YY-2YY overlay with Federal Fund Rate
Federal Reserve cut rates in Nov 2019, just three months after the Curve Inversion (This also shows that Fed is responding quicker to economic slowdown).
What does the Curve Inversion predict? Rate Cuts. And the rate cut did happen; hence there is no reason for the short-term yields to remain elevated.
Why was the bond market pricing in rate cuts in Aug 2019? Was the economy doing badly back then? Lets dig.
Yup, it was! And then Trump pressured Powell into cutting rates.
And because of that, a potential recession was averted. The market continued to rally after the rate cut. This is the S&P500 chart.
Suppose the bond market were to react a few days earlier, then perhaps the curve inversion would not have occurred. The 10YY - 2YY would come close to "0," but it would not cross below zero. Then we would not have the absurd implication of yield curve inversion predicting covid19 put forward by the hippie lunatics.
By understanding the underlying mechanism of the curve, we can make an analysis holistically instead of looking for the black-box cut-off numbers like "OHHHH 10YY -2YY BELOW ZERO... ZOMG!!!, RECESSION COMING IN SIX MONTHS Y'ALL!!!!"
Ironically, this rate cut in Nov 2019 probably cushioned the US from the Covid19 shock, as rates were already down to 1.5% from 2.5% when Covid19 hit early 2020. Jerome Powell probably had a sigh of relief. Someone should give Trump an award for pressuring Fed to cut rates.
We did not hit a recession in 2019 from curve inversion because Fed pivoted. Fed was able to pivot then because.... inflation was not an issue!
With proper knowledge, the deep curve inversion in 2022 becomes extremely easy to explain.
10YY - 2YY
Why is the Fed not cutting rates now while the bond market is begging for one?
Because inflation is a BIG ISSUE.
Inflation did come down for the past few months, but it is still at 40 year high. This makes the Fed reluctant to cut rates, even at the risk of recession.
Looking at the S&P500 and the curve inversion date in 2022, we witness a market sell-off on the first curve inversion.
The market is neither selling off nor rallying after the 2nd curve inversion. It is sideway, for now. There is an explanation for this also. Try to work it out and comment! Here's the big mistake. We ARE NOT SUPPOSED to be using curve inversion as a black-box signal to justify market movement and then start making stupid trades on non-existent signals.
Every economic cycle and market depression has its little nuances. We must be able to analyze each economic cycle on its merit. Inflation was not even a core consideration when Fed was cutting rates back in the housing crisis (2008) or the dot-com bubble (2000).
But it is now in 2022/2023. Inflation is the main reason why Fed cannot cut rates too soon.
Is the Curve Inversion predicting a market crash? Nobody knows.
Is the Curve Inversion predicting a recession? It may or may not happen.
Is the Curve Inversion predicting a Fed Pivot? Yes, it is, but we also know why Fed cannot cut rates.
What does it mean going forward? To be honest, nobody knows. Is the stock market leading? Absolutely not! We have witnessed the stock market rally on pivot expectations only to get crushed by the Fed's resolve to push rates higher. Is the bond market leading? Perhaps. We know the curve inversion is the bond market crying for a rate cut. Will the Fed stay resolved, or will they blink? Nobody knows except for Powell. Is the Federal Reserve the leader? Fed has warned the bond market NOT to ease the financial condition prematurely, but the bond market went ahead and crashed the 10YY to 3.4% from 3.9%.
Does Fed feel that the recent drop in CPI is enough to give in to the Bond market's demand? If yes, then the bond market is leading. Fed will cut rates; the yield curve will become normal, sloping up again. The stock market will rally following this news. The big "but" here is, will inflation spike up in the subsequent months after the rate cut? This is a huge risk that Fed needs to consider carefully. What if the Fed does not give in and hikes the rate higher? Then the curve inverts further and remains inverted until the rate cut happens. This makes the yield curve STILL a leading indicator for rate cuts, but it is vague on the time frame (the cut MUST happen at some point). The stock market will crash following this news.
In both cases, the Stock market is lagging. Sure, the market can lead first in wherever direction it wants, but if it leads wrongly, the swing toward to opposite direction can be very dangerous for market participants. Do the participants want to play such a dangerous game
Since the 2nd curve inversion in Jul 2022, S&P500 has been going sideways without a proper trend. If you think that the market has been moving violently recently, you have to understand that to the institutional funds, a significant movement is about 15-20%. Smart money does not use CFD accounts trading US500 and then run with profit on a 0.5% "swing."
The market is a lost dog folk. It is equally as confused as everyone else.
This is the stock market now.
At least the bond market knows what it wants. Any competent hedge fund manager will tell you that the Bond market always, ALWAYS leads the stock market. But, it is not leading in the way retailers think. When retailers think of leading indicators, they will go into that shortcut analysis of "This line goes up first, so I buy. That line goes down first, so I sell."
Hedge Fund traders understand what curve inversion truly means. It is not just a line with a threshold checklist at 0.00 cross-over. They understand the nuances of each economic cycle and how the stock market reacts. They understand that when the market is blur AF, they need to adopt a neutral bias portfolio and pivot to bias play as direction becomes clearer. When the yield curve is inverted, it is the start of an investigation. It is not a conclusion that yells, "HOLY SHIT RECESSION IN [Insert random number] MONTHS!!!" Rise above and beyond my fellow traders. Discard any shortcuts, checklists, and black-box mindsets. Trading is a skill set that provides unlimited scaling on your wealth. Please respect it.
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