Last week, the big headline economic report was December Non-Farm Payrolls. The jobs report usually gets a lot of attention, but that’s especially the case nowadays since the Fed is paying so much attention to it in helping to direct monetary policy decisions. Powell cited the labor market as the primary reason that he needed to see “substantially more evidence” before even thinking about cutting interest rates. That’s why I don’t think we’re going to see a cut until at least 2024.
But that’s part of the big battle that’s going on in the financial markets right now. The Fed believes that it will keep interest rates elevated through the end of 2023. The bond market isn’t buying it. The Fed Funds futures market is currently pricing in quarter-point rate cuts in both Q3 and Q4 of this year.
I think if the bond market is correct, we’re probably looking at a recession arriving sooner, but there’s a chance that the economy might achieve the soft landing. If the Fed is right and we don’t get a cut until 2024, we’re very likely looking at the hard landing scenario, which potentially sends stocks even lower than in the first scenario.
That’s why I’m not really putting a lot of weight into what the jobs market is telling us right now (and why I’m not buying into Friday’s rally). The historic disconnect we’re seeing in the bond market right now is telling us that things could get really ugly.
Here’s the chart of the “recession indicator”, or the 10-year/3-month Treasury yield spread. An inversion is generally a strong predictor or an impending recession, but the degree to which this spread is negative is truly remarkable.
The 10-year/3-month spread is all the way down to -112 basis points, the lowest it’s been since all the way back in the early 1980s!
The short end of the curve tends to be a reflection of what the Fed is doing. The long end tends to be a reflection of what the economy is doing. Any time you see such a disconnect happening in the bond market, it’s a warning that something could break, market volatility could take off and risk asset prices could take a big hit, even beyond the 20% that the S&P 500 lost last year. One of these two things is hugely mispriced and it’s going to correct, probably quickly, when we get some more clarity.
This spread is usually pretty volatile over time, but the swiftness and magnitude of the change happening in the bond market is something we’ve never seen before.
Just 8 months ago, the 10-year/3-month spread was 227 basis points. This was just before the market started believing that the Fed pivot was coming, recession might be avoidable and it was time to get back into stocks. Equities rallied from June through August, but you can see that the bond market never bought the rally. It kept pricing in higher recession risk throughout since the long end never kept up with the short end of the curve.
Today, that spread is at -112 points. The bond market is getting more and more pessimistic about the economy as the Fed remains stubborn about monetary policy. The larger this number grows, the greater chance of a hugely volatile and negative outcome for the financial markets. If the Fed stays the course, I wouldn’t be surprised to see this gap get even bigger.
I noted on Twitter last week that this spread has expanded by 50 basis points in just five trading days. To give you a sense of how much of an outlier that is, there have been more than 15,000 rolling 5-day periods going back 50 years. This move ranks as the 57th largest negative swing over the past half century.
If you thought that long-term Treasuries falling 30% at the same time the S&P 500 fell 20% was an historic outlier (and it was), what we’re seeing today in Treasury yields is just as significant.
So the Treasury yield curve is #1 on my “things to be concerned about” list. A close #2 is the December services PMI report.
The monthly number came in at 49.6. Remember that any reading below 50 indicates a contraction in activity. Translation: the services sector is now in negative growth territory along with the manufacturing sector. Take away the pandemic flash-recession and this is the first time this number has dropped below 50 since 2009.
This is significant because one of the biggest arguments for the idea that recession is still far away is that the services sector has been strong. Even though manufacturing activity continues to shrink, consumers are still spending on travel, vacations and experiences even though they’re not spending as much on “things”. Since services count for such a big percentage of overall GDP, strength in the services sector should mean strength in the economy as a whole.
Well, this is no longer the case. The services sector is no longer supporting the economy in the way that it was. Sure, it could rebound again, but the steep decline suggests it may not be just a one-off. Services sector activity had been pretty healthy before this, so there’s a chance it’s an outlier, but given the preponderance of data elsewhere, this is probably the beginning of a longer negative trend.
In summary, the equity markets generally reacted positively to last week’s jobs report, but I think that’s a mistake. The shape of the Treasury yield and the fact that the services sector is now contracting paint a much more negative picture from a 30,000 foot view. I think a lot of investors are still trying to squeeze every last drop of blood from this turnip in terms of upside return capture. I think the focus should instead be on downside protection and probably quickly.
ETFs In Focus
In case you missed it, last week I published a piece on four income-focused ETFs that currently yield more than 10% (read HERE). I discussed them in the context of fitting into a retirement portfolio, but they can be useful for almost anyone looking to generate a little extra yield from their portfolios.
I’d encourage you to check it out because understanding how these ETFs work and what their strategies are is important before committing your investment dollars. They’re somewhat non-traditional in how they work, but can be a great addition when used appropriately.