Over the last few days, we have seen a number of reports
cementing the fears that many have had for some time, that a recession, be it mild or otherwise,
is now being talked about as a 2022 event. Now couple this with the fireworks of a 9.1%
inflation number last week, and we now have the most inverted US Treasury yield
curve looking at the difference between a 30-year and 2-year yields since 2007.
And I don't think I need to remind anyone what came next. That is this week's Big Conversation.
Let's begin with some important context. The Federal Reserve Bank of Chicago published
a research note back in 2018 that pointed out the fact that the yield curve slope has become
negative, commonly referred to as an inversion, before each economic recession since the 1970s.
That's a pretty good track record. The explanations for why this has been such
a reliable indicator vary, but for the sake of simplicity, we can think of it as follows:
during periods of strong economic growth, monetary policy acts as a countercyclical measure to reduce
economic excesses. As central bankers tighten policy, i.e. raise short-term interest rates,
it slows down demand by increasing the cost of credit creation. So far, so good. Then,
at a certain point, this tightening effect tends to lead to fears of demand destruction
and thus reduces the market's expectations for long-term growth potential, and as longer-term
growth expectations fall, so do longer-term bond yields. Now, using this logic, one can understand
some of the recessionary fears that began to surface when the curve initially inverted in
April of this year. But over the ensuing months, nominal economic data here in the US, that's
not adjusted for the impact of rising prices, has remained relatively robust. For instance,
nominal retail sales has shown a year-on-year increase of 7.8%, 8.2% and 8.4% over the past
three months. That's pretty solid stuff, and this has led many analysts to conclude that
there is no sign of an impending recession, which is likely why we saw the curve un-invert over the
ensuing months. In layman's terms, despite an increasingly hawkish Federal Reserve,
it appeared as though investors weren't convinced that we had reached the demand destruction phase
of this cycle's monetary tightening. However, and this is key, if we were to remove the
impact of rising prices from strong data such as retail sales or even wages, we can see that these
figures have actually been contracting since March of this year. But then came the June CPI report,
which appears to be shifting the narrative. The tens minus twos curve fell deeper into negative
territory and is now the most inverted since late 2000. And the '30s minus 2's curve also inverted
but for the third time this year, and is now the most negative since 2007. Not great periods
for comparison. To some, the message is clear. Although the Fed has been aggressive in raising
short-term interest rates, its latest move being a hike of 75 basis points, the latest data suggests
there is more to be done in combating inflation. And while there's a whole host of leading economic
indicators suggesting that growth may begin to slow, a more aggressive stance from the Fed
raises the risk that we're rapidly approaching that tipping point of severe demand destruction.
Now, these views were crystallised by a handful of strategy reports from major banks this week,
such as Nomura and Bank of America, who are now predicting a recession by the end of this year.
So what does this mean for markets and for the economy? Well, an inverted yield curve typically
flags a reduction in lending activity. Banks just simply aren't incentivised to lend at lower rates
into a slowing economy. Now plus, bank health itself also comes into question as the industry
typically struggles with narrowing net interest margins. That's the difference between the rate
at which the banks lend versus the rate at which they can borrow. It's one of the primary ways
that banks make money. Now, obviously, earnings expectations for the overall market fall as
recession fears increase, which means those cheap valuations may not be as appealing once you factor
in a drop in earnings. And we still haven't seen major downgrades to 2023 earnings yet. And yes,
all of this has larger implications for the future path of monetary policy. If we are indeed
headed for a recession, it stands to reason that the Federal Reserve will again act as a
counter-cyclical force. And one way of viewing the market's expectation for monetary policy
is to look at another yield curve, this time in the Eurodollar futures market. The underlying
instrument in Eurodollar futures is a Eurodollar time deposit with a three-month maturity.
Effectively, it's an instrument to bet on where you believe ultra short-term rates will be at
a given point in time and one that tends to move directly in line with Fed Funds Rate.
The December 2022 Eurodollar futures contract is essentially the market's expectation for whether
three-month time deposit rates will be at December expiry. And it's in the Eurodollar futures markets
where we've seen another interesting development over the past several weeks. Despite calls for
the Federal Reserve to begin cutting rates in September of 2023, some market-based indicators,
such as the spread between June '23 and December '22 Eurodollar futures,
suggest the Fed might begin cutting rates in the first half of next year. The first half of 2023,
which is extraordinary given how fast the Fed is raising now. But this does make sense
if the market is increasingly of the view that a recession is a 2022, not a second-half 2023 event.
To dig deeper into what this means for the markets and the economy, I sat down with Indrani De,
Head of Global Investment Research, FTSE Russell Index Division of LSEG.
Indrani welcome to the Big Conversation.
Thanks, Jamie. So glad to be here. Thanks for having me.
So this week we're talking about the shape of the yield curve, shapes we actually haven't
seen for about 15 years or so, and I want to dive into what this means for us as investors,
what it means for the different asset classes. But first and foremost, before we get to that,
I would love to get your take on inflation here and
whether we're seeing enough demand destruction to affect inflation.
Absolutely. I mean, inflation is obviously the question of our times. I will break that
question into two parts, because today's inflation is both a combination of excess demand
and supply shortages. So the reasons if it's going to roll over or not come from both sides.
So quickly on the supply side, obviously the disruptions happened post-COVID and more so after
the situation in Ukraine. Now, on that front, we are seeing some improvement, meaning it's not just
oil prices that have come down, but our broad CRB commodity indices, they are down about 12%
month to date. Your shipping rates have come down, and, you know, the New York Fed actually
runs a global supply chain pressure index, which has also come down. So there are hopeful signs on
the supply side, not perfect at all, but better than where they were maybe a month, month and a
half back. Now, coming to the demand side, which obviously Federal Reserve Bank and all central
banks control, that is their number one priority. At any cost they have to control inflation is
their message to the market. And you're seeing that that, you know, the expected rate hikes
end of July will take us to the neutral rate, and the Fed has indicated they'll go on to their
restrictive rate territory. Now, that is priced in by what the markets are saying in terms of
where does the Fed Fund Futures curve peak and roll over, which accordingly means when
are they pricing in a recession and rate cut? Now that expectation of recession,
where we started at the start of this year and then we are now it's really gotten pulled
in, and right now markets are pricing that, oh, by end of this year we will be in a recession
early 2023, the Fed will, you know, possibly start cutting rates. So this is on the actual inflation
demand supply indicator side. I do want to quickly touch upon the inflation expectations because
that's very important to the Fed, and expectations from the financial markets. And you see the market
expectations of inflation, that has come down quite a bit in June. And even the consumer survey
that University of Michigan runs, the longer-end inflation expectations have come down. So one
would think that by all these indicators, market is expecting that the Fed will be successful
and maybe by end of this year we will see a much better picture of inflation than where we are now.
Indrani, you make a great point there actually to monitor not just inflation,
but inflation expectations. Now, secondly, let's talk about the shape of the yield curve
now and what it means for us as investors and what it means for asset classes.
You know, that's a very interesting point, because the sovereign yield curve is really
the foundational asset class for everything that happens in the financial markets. And again,
instead of just watching individual points on the curve, we like to watch it more on averages,
meaning like the World Government Bond Index that we have at the 7 to 10-year duration and
at the short end, 1 to 3-year duration and the difference being the slope. So obviously the
slope has distinctly flattened. We have gone into inversion territory. That's point number one. And
the point number two is at the long end we seem to have peaked and come down a little bit. Now,
when you see these two important data points, couple of things that's important.
A for particularly for a long horizon, income oriented investors, fixed income, particularly
in the longer duration investment grade, may now be providing enough income to become a much more
viable asset class than it had been in recent years. Second thing that's very important is
we remain, and will probably continue to remain in a period of high economic uncertainty, when
in that environment volatility remains high. So one might be interested in positioning for a lower
volatility side of the asset classes. Then commodity prices, while they have come off their
peak somewhat, but again, commodities run in long cycles, so chances are that we could be having
commodity prices that remain higher than what we are used to over the last 5 to 10 years. And this
whole rate curve also has implications for equity markets, particularly on the factors front value
relative to growth. And we have seen the value outperformance year to date for similar reasons.
Well, if you don't mind, let's let's stick on that topic. Now, I'm not asking you to
call equity markets per se, but we've had growth outperform value for such a long time. And now
that that trade has flipped, do you expect growth to outperform value for the next several years?
You know, you touched upon a core point that I would have raised that essentially on this
whole value / growth spectrum, these tend to follow long cycles. Now coming again to
addressing the question in terms of the drivers, where we are right now, if rates are high,
then the discount factor for your growth companies, the discount factor is more
that makes growth competitively less attractive. Similarly, it's not just higher rates. It's also
the fact that we are in a quantitative tightening period. Liquidity is getting drained out, and in
that situation, when valuations get compressed again, the growth companies get hit more.
And we had recently talked about the high economic uncertainty. Now, when you are in a
period of higher economic uncertainty, cash flows and earnings that are far out into the future,
they become more risky. So these are all triggers that make value relatively more attractive
in this particular cycle. And I do want to address that because these are
long cycle things. You know, the mathematical concept of distribution, there is always mean,
mean reversion that kicks in at a certain point. So the things that we talked about,
they are think of them like the triggers, but by the concept of mean reversion,
if we had ten years plus of growth outperforming, there are higher chances that we will be in for
a period when value outperforms. And we have seen that year to date specifically in the US,
in the Russell 1000 space, if you look at the Russell 1000 Value and the Russell 1000 Growth,
year to date, while both are in negative territory, but the Russell 1000 Value has
outperformed its growth counterpart by close to 13 percentage points, which is fairly significant.
Well Indrani, it's great to have you back on the show. Thank you so much for joining us again.
Markets have a habit of making us feel that things are moving very fast when often the real
takeaways from a week should be noticing moves in slightly longer term trends. Indrani makes a great
point there that yes, equities have been under pressure from rate hikes, but also keep in mind
that fixed income, especially at the long end, has been unattractive for investors for a long
time. Now we're still not seeing great returns now, but as the long end picks up,
it means that it will drag some money from other asset classes with it. And lastly, be sure to
keep an eye on inflation expectations as well as inflation itself, because it's often that delta
that will affect markets the most. Thanks for watching and we'll see you next time.