Ignore the Yield Curve Inversion At Your Own Peril

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Jesse Pound and Sarah Min of CNBC report the Dow climbs more than 100 points as Wall Street begins second quarter on a positive note:

Stocks were modestly higher on Friday as investors assessed a new quarter of trading and a troublesome bond market recession indicator.

The S&P 500 rose 0.34% to 4,545.86, while the Nasdaq Composite gained 0.29% to 14,261.50. The Dow Jones Industrial Average added 139.92 points, or 0.40%, to close at 34,818.27 after being down more than 100 points earlier in the session. Stocks closed near session highs.

The gains for stocks came on the first trading day of April and the second quarter. Wall Street is fresh off its first negative quarter in two years, but there were positive signs for investors on Friday.

The price of U.S. benchmark West Texas Intermediate fell below $100 per barrel as the Biden administration pledged to release more strategic oil reserves. Energy prices surged earlier this year as Russia’s invasion of Ukraine disrupted global supply, leading to some worry that the high prices could hurt economic growth.

Investors were also digesting the official jobs report for March, which showed the U.S. economy adding 431,000 payrolls. The result was below the composite estimate of 490,000 from Dow Jones but above some of the lower-end estimates.

“With some sentiment indicators in the U.S. pointing in the wrong direction, the jobs data also came in weaker than expected, but not as bad as many would have feared given the backdrop,” said Neil Birrell, chief investment officer at Premier Miton Investors. “Job vacancies are still being filled and wage growth remains robust, suggesting that the economy is in good shape. That is the case for now; the key will be the impact on the jobs market and broad economy as rates jump higher and growth slows.”

Materials stocks moved higher, with Freeport-McMoRan rising more than 2% and gold miner Newmont rising nearly 4.2%. Health care, utility and energy stocks also outperformed. Edwards Life Sciences and Illumina rose more than 4%, making them two of the top performers in the S&P 500. Walmart rose more than 1%.

U.S.-listed Chinese stocks jumped on Friday after a report that China was considering sharing company audits with foreign regulators.

Investors appeared to largely shake off a recession signal from the bond market that was triggered after the closing bell Thursday and again on Friday morning. The 2-year and 10-year Treasury yields inverted for the first time since 2019.

For some investors, it’s a signal that the economy is headed for a possible recession, though the inverted yield curve does not predict exactly when it will happen, and history shows it could be more than a year away or longer.

“It is a warning about whether the Fed is going to be able to land this thing properly. And I think that’s a valid concern,” said Keith Lerner, co-CIO and chief market strategist at Truist Advisory Services. “But most of the data by itself suggests that the yield curve itself is not a short-term sell signal.”

Lerner added that the market appeared to be shifting toward leadership by more defensive stocks in recent days.

Bank stocks struggled on Friday after the inversion, with Citigroup losing 2%. Chip stocks fell again on Friday, with Intel dropping nearly 3% and Advanced Micro Devices losing about 1%, amid growing concern about personal computer demand.

There were some more negative economic readings on Friday, with February construction spending data and March manufacturing data from ISM coming in below expectations.

The three major averages slumped on Thursday to close out the first negative quarter for stocks in two years, with losses accelerating in the final hour of trading. The Dow and S&P 500 ended the quarter down nearly 4.6% and 4.9%, respectively, during the period. The Nasdaq dropped more than 9%.

The start of the Fed’s rate hiking cycle, persistently high inflation and the ongoing war in Ukraine contributed to the rough quarter for stocks.

For the week, the S&P 500 squeaked out a slight gain while the Dow declined 0.12%. The Nasdaq added 0.65%.

And so begins April, typically a good month for stocks but that's when the Fed isn't warning that it will raise rates by 50 basis points to tamp down inflation.

I agree with those who state overall it was a strong jobs report and there's no reason for the Fed to do anything other than raise by 50 basis points at its next meeting:

With inflation still running hot and employment growth remaining solid, there's no reason for the Fed to keep going incrementally by raising rates 25 basis points at each meeting.

And even if headline inflation abates, core inflation will remain at high levels, and that is what the Fed typically looks at according to Francois Trahan of Trahan Macro Research.

Earlier this week, Francois had a great conference call on "Dr. Housing's recession warning and what it means for stocks."

I'm only going to share one slide which summarizes it all but take the time to listen to the full conference call:

Please do not redistribute this slide unless you have permission from Trahan Macro Research. 

This just gives you a summary, the details are important which is why I urge you to listen in on the conference call. 

So, if recession lies ahead, how come the US labor market remains strong?

Because employment is a coincident indicator, not a leading one. 

Still, the decline in real wages is pointing to a recession ahead:

A leading indicator is the ISM New Orders index which dropped considerably from 61.7 to 53.8 in March:

Just that tells me the US economy is slowing even if the reading is above 50 (indicating growth).

And then there's the yield curve. Everyone is talking about how it inverted and is pointing to a recession ahead and making the Fed's job to fight inflation more difficult:

It's not just that the yield curve inverted, it's the speed of inversion which matters here:

What also matters is the inflationary regime we are currently experiencing:

Not just in the US but in Europe and elsewhere:

All this to say, when the yield curves inverts in an inflationary environment with a hawkish Fed, watch out, it's flashing recession ahead.

In his latest weekly market wrap-up, Martin Roberge of Canaccord Genuity warns that inversion is here:

Our focus this week is on the 10Y-2Y bond yield curve, which has now inverted. This topic received a lot of press this week and we wanted to set the record straight, as we are seeing a lot of data mining with regard to market performance after inversion. A key issue, in our view, is the sample set used. Many analyses report only the last five inversions, which carry bullish implications for stocks, as we can see in the second panel of our Chart of the Week. The problem with this sample is that it looks only at inversions in a low-inflation regime (1988-2019); that is, inversions through a secular bull market in bonds. Going back further and looking at the high-inflation regime that prevailed from 1965 to 1981, we can see that the seven inversions through a secular bear market in bonds led to a much more bearish outcome for stocks (first panel). While the bull case for stocks is to argue that we may be only temporarily in a high-inflation regime, we beg to differ. Therefore, as much as our market focus in Q1 was on buying dips, entering Q2 we are shifting our focus to selling rips. More colour on our market/sector thoughts is in the April 2022 edition of the Quantitative Strategist, published this morning. Also, a webinar to review the key highlights will be held next Tuesday at 2pm.

The message is clear, in a bond bear market where inflation pressures persist, do not ignore the yield curve inversion, it's signalling a recession lies ahead. 

This is why Martin has shifted his recommendation from buy the dips in Q1 to sell the rips in Q2.

Now, a little pause here because I always get some wise guy trader telling me stocks have done well the last couple of weeks.

So what? End of quarter window dressing and/or stock buybacks don't impress me. 

Stocks might continue to do well in April but I've lived through nasty bear markets and seen these violent counter-trend rallies plenty of times.

These bear market rallies are impressive but they ultimately fizzle out and stocks make new lows.

This doesn't mean you can't make money trading swings, it means you need to manage your risk a whole lot tighter in this environment:

Those of you who aren't comfortable trading stocks, stay defensive in this environment and never mind what bullish strategists are recommending. 

So, if anyone tells you to ignore the yield curve inversion in this environment, tell them they're going to get their head handed to them and refer them to this comment.

Below, CNBC's Steve Liesman joins 'Squawk Box' to report whether a recession could be on the horizon after the 2-year US Treasury yield topped the 10-year rate.

And Steve Weiss, CIO and managing partner of Short Hills Capital Partners, joins the 'Halftime Report' to discuss why he's still cautious on the markets.

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