Yield curve says recession, but is this time different?
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--------------------------------------------------------------- [[FREE] Is The US Approaching A Recession? A Masterclass by The Pragmatic Investor]( Yield curve says recession, but is this time different? [James Foord](jamesfoord) Aug 6 ∙
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9 months ago · 3 likes · James Foord However, the topic of today isn’t stocks, but markets in general. Following the bloodbath in markets, it’s time to review what’s going on with the macro side of things.
Why Is Everyone Worried About A Recession? Even though the S&P has rallied over 40% since it bottomed in October 2022, this bull market has been met with considerable scepticism. With some of the major indexes selling off sharply last week, bears and economic fearmongers have crawled out to the woodwork once more, claiming a recession could be right around the corner. In my opinion, there’s still not sufficient evidence to suggest that the US economy is going to weaken significantly, quite the opposite. However, before we lay out why a US recession is not likely at this time, let’s address the main reasons why investors believe a recession should happen. The Inverted Yield Curve The yield curve is a graphical representation of interest rates on bonds of varying maturities, typically government bonds, at a given point in time. The most common yield curves compare short-term and long-term interest rates. An inverted yield curve has preceded many past recessions, making it a closely watched indicator. It reflects investor sentiment that economic conditions will worsen. Investors moving their money into longer-term bonds (causing long-term yields to drop) indicate a lack of confidence in short-term economic performance. The yield curve inverts. When short-term rates exceed long-term rates, it usually happens due to monetary policy tightening, which can contribute towards economic weakness and lead to a recession. The Federal Reserve then cuts rates as a response and the yield curve uninverts as a recession happens. Above we have the historical difference between 10-year interest rates and 2-year interest rates to put this into perspective. We can see that the yield curve has inverted four times since 1989. Every time a recession has happened following an inversion just around the time that the yield curve uninverts, which may happen soon.
The Fed Cutting Cycle This is exactly what we can see reflected in the chart below. As the headline clearly states, over the last three cutting cycles, it has made sense to sell the first rate cut. Odds now are that we should see a rate cut by September. Could this mark the top in markets and the start of another recession?
Rising Unemployment Lastly, we need to talk about unemployment. After seeing unemployment fall throughout 2022 and 2023, we have now seen a clear upward trend in the unemployment rate, which has now reached 4.2%. While this is still low, we can’t deny the fact that once an upward trend begins unemployment, it continues to rise into a recession, and only begins to come down after one happens.
Why This Time Could Be Different A recession, given enough time, is an absolute certainty. But does that mean we should be worried about one now? While the yield curve has traditionally been an accurate recession indicator, the situation today is actually quite different. A simple chart holds the answer to this. This is a snapshot of the Federal Reserve balance sheet. Since 2008 when the Federal Reserve started its QE programme, the Central Bank’s balance sheet has swollen to over $7 trillion, even after some recent tapering. And that's not all. Federal Spending has also followed a similar path, especially since the COVID pandemic hit and the government responded with unprecedented stimulus. These high levels of fiscal spending have indeed become the new normal. Why does this matter? We can think of it in terms of the real economy and stocks.
The US Economy Remains Strong In terms of the Real Economy, while large amounts of monetary and fiscal stimulus can bring about inflation, they are generally supportive of economic growth, especially in nominal terms. As we can see, GDP grew very strongly after 2020 and has been growing at over 2% since. Even the latest data has come in strong. In practical terms, monetary stimulus, lowering rates and central bank asset purchases, helped consumers lock in low interest rates for the long term, while also increasing their savings. Since COVID, average hourly earnings have grown faster than before. The consumer is flush with cash and is not near any meaningful risk of default. This chart shows the ratio of financial obligations of US consumers. It measures the percentage of income that a person needs in order to meet their financial demands (mortgages, car payments etc) This is still near historical lows, again, thanks to COVID-19 stimulus. And the same can be said of corporations, which also benefited from government programmes during COVID. They now have stronger balance sheets and are steadily increasing their profits every quarter.
How Stimulus Affects Stocks Another way to think about this is that monetary and fiscal stimulus are adding more “liquidity” to markets, something which stocks really like. As we can see, liquidity holds a strong correlation with the S&P 500. I discussed liquidity in-depth with a real export, Michael Howell, a couple of weeks ago. He believes the liquidity cycle still has some ways to go, and that certainly seems to be supported by what is happening: - The Federal Reserve is beginning to cut - China’s PBoC is [beginning to ease]( rates - Fiscal spending continues to trend up, which is unlikely to change no matter who sits in the White House All in all, we have the perfect recipe for stocks and financial assets to rally from here. The economy remains strong, but with inflation nearing the Fed’s target, we will likely also see an easing of monetary policy. This is the ideal zone that economists call “Goldilocks”.
How Do We Profit From This? However not all assets are created equal. In the immediate term, as liquidity returns to the markets, there are opportunities to profit in the more speculative and currently underperforming areas. There are three assets particularly that I am looking at closely: - Small Caps - International Stocks - Bitcoin We have now witnessed a significant divergence between the Nasdaq (NDX) and the Russell 2000 (IWM). While the large-cap index has fallen around 5% the small-cap index rallied in the last few weeks. Could this indicate that small caps are ready to catch up? This aligns well with our macro outlook, where a supportive stance from the Federal Reserve may re-embolden investors. Additionally, if the People's Bank of China (PBoC) keeps easing, it could greatly benefit Emerging Markets (EEM). This index remains well below its all-time highs and has just reclaimed its 200-week moving average. From a longer-term perspective, if we consider that monetary inflation might become more common in the coming years, Bitcoin (BTC-USD) could be an excellent hedge. Since its inception, Bitcoin has been a strong monetary hedge, tracking the rise in global liquidity. It can be viewed as "exponential gold."
Final Thoughts In conclusion, the situation today is very different from that of the past, which is why typical indicators like the yield curve may not be accurate in predicting a recession this time around. A recession will eventually happen, but it will take a lot longer to materialize. Why? Because the US economy (consumers and corporations) is still riding high on the unprecedented amount of stimulus from the COVID era. Furthermore, I believe the odds are the future holds more fiscal and monetary stimulus, not less. With that said, I believe investors can now strongly benefit from getting exposure to small caps, international stocks and Bitcoin.
That’s all for this week! Thanks for reading! I hope you enjoyed this deep dive on markets and recessions. Subscribe to receive regular updates on stocks and trading! [Check out The Pragmatic Investor]( A guest post by
[James Foord](jamesfoord?utm_campaign=guest_post_bio&utm_medium=email)
Hi, my name is James and I have been studying and writing about stock markets for the last seven years.
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