Yield-Curve Inversions, Higher Rates and Recession

With two key interest rates out of their typical alignment at the start of last week, there has been much discussion in the media — and likely worry among investors — about inverted yield curves and higher interest rates as well as the possibility of recession. Most observers are focusing on the difference between rates on 2-year Treasurys and 10-year Treasurys, the so-called 2s/10s curve. Recessions are typically preceded by an inversion of that curve, which is why the curve’s move early last week drew so much attention. But an inversion doesn’t always result in recession. Moreover, there are different points on the yield curve. The 3-month, 10-year curve, for example, remains fairly steep (not inverted) and is growing steeper, which indicates little risk of an imminent recession. What’s more, the 2s/10s curve ended the week back in its un-inverted relationship.

To be sure, yield curves are one data point worth monitoring. While we don’t think a recession is imminent, at some point a recession is inevitable. Still, current data suggests that when it happens, the next recession will likely be mild. Recessions and the anticipation of a recession can drive equity prices lower, which can be unnerving. But the reason equities produce such wonderful long-term returns is because every so often they don’t. That’s a feature, not a flaw, because if owning stocks were risk-free, investors wouldn’t get paid a premium to own them. A market downturn, therefore, builds the foundation for the next wealth-building series of returns.

When it comes to interest rates, quite simply, the bond market has already adjusted, pricing in the six or more rate hikes anticipated between now and next year. As a result, there isn’t anything for investors to do at the moment.

Wall Street wrap

Overall, stocks took a bit of a breather last week with the S&P 500 down 1.27 percent, coming back from midweek lows on Friday to some degree. But the tech-heavy NASDAQ peeled off about 3.86 percent.

Despite investor concerns about threats to its role as the world’s reserve currency, the dollar moved higher throughout the week, at one point on Friday topping the 100 level on the six-currency dollar index, a two-year high. When the going gets tough, the world still flocks to the U.S. buck.

Brighter services picture. The Institute for Supply Management (ISM) Services Purchasing Managers Index released Tuesday was mostly in line with expectations, showing firming employment components and a rise in new orders for the first time in four months. This is encouraging and confirms that consumers are switching from spending largely on goods to spending more on services. As we have been pointing out, part of what has driven inflation was a pandemic shift in spending: Consumers bought more goods than services, which strained supply chains. As consumers shift to more spending on services rather than goods, this inflationary pressure should ease.

Continued strong employment. Jobless claims dropping to 166,000 produced the lowest reading since 1968. The labor market remains tight, with five million more openings than available workers, although millions more workers are reentering the labor force, as pandemic relief programs have largely ended. We believe there is still hidden slack that can ease labor-market pressures and dampen wage inflation – an aid to a Federal Reserve trying to satisfy its dual mandate of supporting maximum employment and price stability.

A slightly more hawkish Fed? The release of minutes from the most recent meeting of the Federal Open Market Committee revealed that the Fed’s balance sheet runoff should cap out at $95 billion per month, reaching that level over a three-month period once it gets started (perhaps as soon as next month). This is in line with market expectations and, perhaps, even a bit accelerated. The minutes also revealed some interest in hiking rates by twice the 25-basis-point increase announced at its last meeting, indicating the mood at the Fed may be turning slightly more hawkish.

The week ahead

As fears of a new Russian offensive mount, sanctions intensify and the humanitarian crisis deepens, hopes for an end to the war in Ukraine ebb. With that, chances for developments that would bolster the global economy and markets also wane. On the domestic front, here are announcements to watch for in the upcoming week:

• Monday: The New York Fed will release its March figures for one-year and three-year median inflation expectations. February data showed median one-year inflation expectations increasing to 6.0 percent from 5.8 percent the month before.
• Tuesday: The big news for the week could come in the form of the Consumer Price Index for March, which analysts forecast will show a 1.2 percent increase, up from the 0.8 percent rise in February. Year-over-year CPI is expected to show prices rising at an 8.4 percent annual rate, compared with the 7.9 percent rate posted last month.
• Thursday: The weekly update on employment and jobless claims numbers is anticipated to show a slight rise in unemployment. March retail sales are expected to be slightly higher than in February, while preliminary consumer sentiment numbers from the University of Michigan may be a bit lower.
• Friday: Reports on industrial production and capacity utilization will round out the week’s picture of inflationary pressure and slack in the economy.

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