Market participants have become conditioned. The majority of commentators expect enduring high and persistent volatility across financial market sectors. Yet, the odds of such an outcome are dropping. Carving out the debate around the inflation theme in isolation or about the low unemployment prints of late, is shying away from the complexity at hand. Instead, it might pay off to look at a set of macro and micro indicators that, combined, reveal a different truth. We briefly assess the conditions of the following ensemble of US indicators: the persistent US yield curve inversion, the mean-reverting powers impacting the value of the USD and the latest US Senior Loan Officer Survey. The US 2’s – 10’s yield curve inversion (2-year rates at 4.52% versus 10-year rates at 3.74%) is getting long in the tooth. About 8 months ago, in July 2022, the FED accelerated policy rate tightening, enforcing yield curve inversion.
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- The shallow January 2006 till February 2007 yield curve inversion, reaching a mere -15bp, signalled deep trouble ahead. Between March 2007 and March 2010, the curve steepened aggressively by about 300bp as markets went through the GFC ordeal.
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- The January 2000 to December 2000 yield curve inversion took 11 months and reached a maximum level at -50bp. Again, the cycle was more predictable and the equity market reset forced the hand of the FED, taking the FED fund rate from 6.5% to 1.75% over 2021.
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- Interestingly, the longest stretch of US yield curve inversion occurred under the Volcker-led FED between September 1978 and April 1982. Volatility was sky-high. Yet, back then, M2 money supply growth averaged about 8.5% YoY. Maximum 2’s – 10’s inversion reached -200bp in February of 1980 versus a level of -78bp today.
Enter US money supply ‘growth’. M2 YoY money supply did not increase but contracted by about (1.3%) over 2022. The wisdom of the bond crowd is reflected in the stability of long rates today as inflation is on a (slow) path south. Bond markets price US Fed policy rates at 3.21% by February 2025. That is 24 months from now, an eternity in markets. This tradable information is an expression that the timing of the pivot is hard to predict, but also tells us that a pivot will occur. The 6-month annualised US PCE (Personal Consumption Expenditure) rate sits just above 2%. The 6-month annualised CPI rate sits just under 2.00%. The one-year market-based inflation expectations averaged 2.25% over the past 6 months. The (core) inflation path will be volatile, but the trend is clear: downwards. The FED steers for disinflation, but also has a mandate that should prevent a bust from unfolding. The FED pushing for a policy mistake and hiking towards 6.00% or higher would lead to a snowballing of negative shocks resulting in a deep recession outcome.
Let’s revisit the ‘Equation of Exchange’ by the economist John Stuart Mill: M*V = P*Y. The equation states that the total amount of money spent within an economy over a specific period is always equal to the total amount of money earned within the same period; or nominal expenditures are always equal to nominal GDP, income. It represents the common expression of the quantity theory of money, which is used to explain changes in the money supply and its relationship to the overall level of prices of goods and services.
Currently, when money supply growth (M) is negative (and slowing deeper into negative territory) and money velocity stable (at the lower end of history) the equation holds the moment the ‘price of things’ corrects to the downside with output holding up….or inflation (P) remains sticky and uncomfortably high (above the mandated 2%) and output (growth) corrects. The latter will translate into an uncomfortable reversal in unemployment. The former is the optimal FED outcome i.e. inflation settling around target with economic output at potential.
As the above equation is an identity, with lags, an equilibrium will be reached.
Returning to the yield curve inversion enigma. The inversion might not have reached its low point at -78.5bp last Friday February 10 if history is our guide. But remember friends, the deeper the inversion goes, the stronger the steepening process that will unfold. Calling peak inversion might be a bit early, but timing such reversals is not a science.
The DXY index (i.e., the dollar index versus main trading partners) closed at 103.63. By the end of September 2022, the index reached a high of 114.78 or a correction of 9.7%. The dollar index averaged 98.70 over the past 55 years. Global trade is supported by supportive USD liquidity. The latter is obstructed by a tightening FED policy and the FED balance sheet contraction at a rate of USD 95 billion per month. The near 10% fall of the USD index exhibits a similar expectation that we are closing in towards the terminal rate. On top, the ECB policy rate expectations for February 2025 are priced at 3.15%….almost exactly the level of US policy rates at that time.
Somehow, the FED’s implicit forward guidance is ticking most boxes that make up their mandate: sustainable and inclusive growth under non-accelerating inflationary rate of unemployment (NAIRU). Global trade can recover the moment USD liquidity normalises…this can occur as soon as terminal rates are set in and the FED that starts echoing an end to balance sheet reduction. Required central bank reserves have received a lift and will permanently be nurtured at higher levels. Steering towards pre-GFC reserve levels would break the financial system. As unrealistic as this might sound today, another series of lower CPI prints will stir the comprehensive (rates and balance sheet) pivot debate.
That brings us to the latest Senior Loan Officer Survey in the US. In Q4 2022, over 40% of reporting banks announced that they tightened lending standards for Consumer and Investment loans. For commercial real estate, 60% of banks tightened lending standards. These micro indicators signal recession risk ahead of us. Residential housing affordability dropped to the lowest levels since records began in 1986. 30-year mortgage rates settle around 6.75%, pushing housing affordability down by 50% over the past 2 years.
The above set of indicators combined reveal that the end of the US interest rate cycle is near. Markets are looking beyond 2023 and started to position for early cycle conditions, even if these only become relevant over 2024. Markets have become impatient in pricing future conditions. Another innovative condition that requires further research.
The moment peak inversion is reached is the moment the steepening yield curve debate gains traction.
