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The Yield Curve’s April Fool’s Joke

| April 22, 2022
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Despite the media's market narrative turning sour to start 2022, the data paints a picture that is not so bleak. This year the news has been dominated by headlines about Russia invading Ukraine, gasoline prices rising out of control, inflation running red hot, and both stocks and bonds producing negative returns to investors. Not to mention whispers of a recession! These fears have had a quarter to marinate in the markets and, in our opinion, have caused them to become oversold in an environment that is stronger than meets the eye.

Compared to the economic growth of 5.5% in 2021, this year's growth is expected to be much slower at a consensus estimate of 2.6%. However, this deceleration is the result of post-recovery normalization, not because we are heading into a recession. Investor fears were amplified when the 2Yr/10Yr yield curve temporarily inverted on April 1st, but this proved to be a good April Fool's joke as the curve quickly began steepening in the coming days.

A much better curve to look at is the 3Mo/10Yr curve. This curve has a more impressive track record for indicating recessions with fewer false positives. Since it is more closely linked with the Fed Funds Rate, it more accurately portrays when the Fed is nearing a policy error. Unlike the 2Yr/10Yr, this curve never even got close to signaling recession in April. On top of that, "the 3Mo/10Yr remains at levels historically consistent with an above-average return environment," according to ClearBridge Investments.

The Fed’s Senior Prank

Currently, markets are pricing in nine rate hikes for this year, which is implied by the Fed Fund futures rate of 2.5%. While this may seem like an extreme amount of rate increase, it is on par with the historical average of 2.6% during the first year of previous tightening cycles. Therefore, seeing forecasts of nine hikes should not be a cause for concern.

*Rates shown for these dates are the rates as of the last hike within the first year and not the rate one year after the first hike of the cycle.

**Change in first year Fed Funds Rate implied by Fed Fund Futures.

Data as of March 31, 2022. Source: Bloomberg.

Furthermore, in an interview with Larry McDonald, he talked about how the Fed is notorious for overstating their intended rate hikes to sell-side banks, then hiking less than consensus estimates during the year. The reason is that the Fed seeks to tighten financial conditions with their words first before they want to officially implement rate hikes, a wily prank pulled by Fed Chair Jerome Powell. We are already seeing a decline in the number of estimated hikes priced into the market. On April 13th, FundStrat published: "Odds of a Fed hike by YE 2022 have dropped from 9 to 8 in just the past 3 days."

Fool Me Twice, Shame on Me

Several concerns have risen amid falling consumer sentiment and Fed tightening, but metrics show that U.S. consumers' balance sheets are possibly the healthiest they have ever been. Before the pandemic, all recent Fed rate hiking cycles started with U.S. consumers reaching higher debt levels than at the beginning of the prior hike cycle. However, this is not true anymore. When the Fed began hiking this year, aggregate consumer debt totaled 77% of GDP compared to 100% of GDP in 2008. In other words, consumers are a bit more immune to rising interest due to their lower relative debt levels.

In 2021, household net worth increased by 14% to $18.9 Trillion. According to Bank of America, if the price of a gallon of gasoline rises by $1 for a full year, it would cost households an estimated $140 Billion. This is less than 1% of last year's increase in household net worth. Additionally, in the face of a year-over-year inflation print of 7.9%, aggregate workers have seen about a 10% increase in compensation. As a result, wage growth has more than offset higher inflation, allowing aggregate consumers to record a savings rate of 6.1%. Thus, despite higher price levels, including a sharp rise in oil prices, Americans are still able to stash away a portion of their paychecks into savings.

In summary, given 1) a misleading yield curve, 2) the Fed's bark tends to be worse than its bite, and 3) the solid health of the U.S. consumer, we believe the market is being excessively spooked. Investors are overreacting to temporary "jokes" and "pranks", i.e., overblown fears of recession, Fed policy mistakes, oil prices, inflation, etc. beyond what is empirically justifiable. The data is showing that the fundamental driver of markets, the economy, is in better shape than the media is willing to admit and is in a stronger position than many investors understand.

Sincerely,

The RMR Investment Committee

 

 

Sources:

The Long View: When Doves Cry | Franklin Templeton

An Interview With Larry McDonald | Conversations with JC Parets - All Star Charts -

Despite major inflation prints, market knocked off 1 Fed hike by YE to 8 from 9 - FSInsight

 

 

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