The mystery of a missed recession, which the yield curve inversion predicted, has bewildered economists and market analysts. When considering the difference between the 10-year and 3-month yields, the inversion started in October 2022, peaked in May 2023, and is still in place. Numerous justifications for the missed recession have been proposed, but most confuse cause and effect, as I will argue below. But first, this chart. If it looks a mess do not worry, I will explain below.
An indicator of an inverted yield curve (IYC) is the 10-year yield minus the 3-month yield. There are other indicators people use, but this appears to be a popular choice. The above monthly chart shows the S&P 500 index, the 10-year yield minus the 3-month yield, and the drawdown of the index.
It may be seen that in the early 1990s, IYC peaked above two mean absolute deviations (MAD) when the strongest uptrend in the recent history of the stock market was about to start. The IYC fell below minus two MAD in July 2000. The inversion coincided with the market top in 2000 and the bear market that followed.
As the dot-com bear market was evolving, the yield curve was steepening parabolically, and by March 2002, the IYC reached the two MAD highs, but things remained volatile for a while, until May 2004, when the IYC peaked and then started falling after another test of the two MAD highs. The yield curve was inverted in August 2006. IYC fell below minus two MAD and near the market top due to the financial crisis.
As the stock market fell due to the financial crisis, the yield curve steepened and reached again above the two-MAD line in December 2009. A new, long-term uptrend in the market began.
By August 2019, the minus two MAD lows were hit again but there was only a short-lived correction and everyone understands why: quantitative easing. The Fed had instituted a stock market put and another bear market, as in dot com and GFC, was no longer possible.
Since late 2019, there have been some interesting developments on the above chart: First, the steepening of the yield curve was interrupted by a pandemic and the recovery was not as fast as during the dot-com and GFC bear markets. There was a brief inversion that lasted a month in February 2020, and the steepening resumed due to excessive monetary and fiscal stimulus. But the upper two-MAD line was never reached because inflation started rising.
The yield curve got inverted again in August 2022 for a month, and despite an even deeper inversion, there has not been a recession, and the market recently made new all-time highs. What happened?
Maybe the answer is that the recession occurred in 2020, even for a brief period, but due to the excessive stimulus in 2020, the interest rate did not increase enough to cause another recession. The result is that, although the yield curve remains stubbornly inverted, the economy keeps going due to the stimulus it received in 2020, while the rates were not raised high enough to cause a recession.
Was there regime change due to an effective monetary policy, or was the inevitable recession only delayed?
Two possibilities, at least:
(A) The stock market uptrend continues, but there will not be a recession due to non-linear lags from the large stimulus. The yield curve stays inverted for a while, and bonds underperform.
(B) A recession is coming; there will be a quick adjustment to market valuations, and inflation will fall along with falling interest rates. Stocks will fall hard under this scenario, and bonds will outperform.
A highly non-linear, chaotic regime
Excessive stimulus and dovish monetary policies have created a chaotic regime. Do you want an economy that has chaotic dynamics? Chaos can break things. Maybe there is no other choice.
I assign a higher probability to A but remain alert for signs that I am wrong and B is correct. Being prepared to accept that you are wrong and act accordingly is important. And, by the way, as far as the stock market goes, I am confident that our quantitative strategies will show the way. Check our latest dynamic momentum addition.