David Rosenberg: How Major Asset Classes Fared After a Yield Curve Inversion


The bottom line is that the bond market sends a warning that a Fed policy error is increasingly possible

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By David Rosenberg and Marius Jongstra


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During the first six weeks of the year, investors focused on the outlook for US Federal Reserve policy and economic growth. Indeed, rate hike expectations have been raised considerably at a time when forecasts for gross domestic product growth are being revised downwards by the economic consensus.

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The aggressive removal of monetary policy easing coupled with a deceleration in the economic outlook is generally not a good mix, a view ratified by the bond market, as short-term yields have risen at a faster rate. than those in the long run of the curve.

For example, the 2s/10s yield curve is at its flattest point since August 2020 at just 50 basis points, collapsing by half since the start of the year, with potential for a reversal if things continue. at this rate. We’ve gone back to the history books to look at the performance of major asset classes over the 12 months following a reversal to help guide future asset allocation decisions.


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From an economic perspective, using the 2s/10s curve as an example, short-term yields outpacing their longer-term peers is not a development to be taken lightly. Historical records show that this event preceded all six recessions since 1980, with a median delay of about a year (14 months, to be precise).

Intuitively, this makes sense, with the Fed in a tightening bias influencing short-term rates higher to dampen inflationary pressures while growth expectations fall (weighing on long-term yields). If nothing changes in the outlook, short-term rates will eventually rise above those on the long end of the curve and this is the bond market’s way of saying that central bankers have gone too far and a recession is approaching.


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The attached chart summarizes the 12-month average forward-looking returns for the major asset classes we track, including the equity sectors, based on these six previous reversals. Interestingly, but perhaps unsurprisingly, the shorter-term nature of equity investors (relative to their bond market counterparts) is on full display, with equity markets continuing their gains on average.

That said, the cyclically sensitive Dow and Russell 2000 indices are underperforming the S&P 500 and the Nasdaq on rising concerns over economic growth. At the sector level, a similar dynamic appears with energy, materials, industrials, consumer discretionary and financials underperforming the market as a whole. Meanwhile, more defensive sectors such as consumer staples, healthcare and communication services (formerly telecoms prior to the 2018 GIC sector reshuffle) are outperforming.


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This development can also be seen in the underperformance of all commodities, as evidenced by the drop in the CRB index, while gold outperforms on average by eight basis points. The only caveat concerns West Texas Intermediate crude oil, which historically tends to rise very late in the cycle, with high prices contributing to the deteriorating outlook. In fixed income, corporate bond spreads are starting to widen with lower-rated products, favoring investment quality over high yield (we’ve also included CCC spreads as a benchmark, indicating that investors would be better off upgrading to B and BB ratings if they are to maintain some high yield exposure).

On the US Treasury side, history shows us that the curve is actually starting to straighten even though the damage has been done. Bond markets are now beginning to price in the potential policy easing ahead, with short-term rates falling faster than their long-term counterparts. Despite this downward pressure from rate differentials, the safe-haven status of the US dollar outweighs the influence of the Fed – generally on the rise over this one-year period.


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The bottom line for investors is that the bond market is sending a warning that a Fed policy error is increasingly possible. At just 50 basis points, there’s not much room for error. Looking at previous up cycles, the 2s/10s curve is typically more than double that amount when the rate up cycle begins with an expansion of only around 30%.

In this pandemic cycle, where everything has accelerated, we are closer to 80% thanks to the expansion and half as stiff compared to the norm. Investors will need to keep an eye on this indicator in the coming weeks as the tightening cycle begins, as a reversal signals extreme development late in the cycle. This means a shift to defensive areas of equities, despite the continued rally in equities, a reduction in general commodity exposure towards gold and crude, an increase in Treasury exposure and a focus on the highest rated names in the corporate bond market.

David Rosenberg is the founder of the independent research firm Rosenberg Research & Associates Inc. Marius Jongstra is a senior economist and strategist there. You can sign up for a one-month free trial at Rosenberg’s website.


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