Central Bank Rates & Yield Curve Inversion - Hard Landing vs Soft Landing

In 2023 the Federal Reserve Bank of America carried out the fastest rate hiking cycle in their long history. In doing so they have created a risk that something brakes necessitating rapid rate cuts and would likely be accompanied by recession. Should this materialise it will be an extremely bad scenario for both US stocks and our global tracker funds. We would likely see a severe sell-off in stocks. This is the 'hard landing' scenario for the stock market.

In the 'soft landing' scenario we have a 'slow rate of cuts', with no accompanying recession. History shows that this is bullish for stocks...

One of the things we watch out for is the rate of global central bank hikes or cuts. An aggressive move up in rates (hikes) means that inflation is getting out of control and that's generally bad for both stocks and bonds...

MacroMicroMe Central bank hikes vs cuts

Interest rate expectations tell us where global central banks are likely headed...

MacroMicroMe Central bank interest rate expectations

Another warning sign we watch out for is the rate of increase of central bank balance sheets. If the balance sheet of a central bank starts to hike up, then it suggests there is something amiss within that country's financial markets and might spell problems for stocks and bonds...

At Boom Bust Invest we cover global financial markets, not just the US SP500, but even so, the SP500 will still be about 65% to 75% of a standard global stocks fund depending on which one you're invested in. For this reason, we do need to watch the Fed more closely...

MacroMicroMe FedWatch Interest rate expectations

MacroMicroMe is an excellent online resource. This article summarises the charts above.

Since 1950, all major US recessions (and there have been 9 of them) were preceded by an inversion of a specific segment of the ‘yield curve’. Click here to see the evidence for this in black and white.
An inversion of the spread between 2 year and 10 year Treasury bonds happens when two year Treasury's yield more than their 10 year counterparts.
It can take up to 34 months for the recession to hit after the inversion. (This Business Insider link (opens new tab) explains this in more detail.)

Yield Curve Inversion in US Treasuries is a strong predictor of recession and with recessions come declines in stock markets. When the eventual recession hits (or even before) is when I would consider taking profits on equities and moving into Capital Protection Assets.

What is the Yield Curve recession probability indicator below showing?…

US treasuries 3M/10Y inversion is a very accurate leading indicator of recession and as can be seen below at the time of writing in 2023 is about twice as deep as 2008 GFC and DOTCOME crash 2000. See the 3M/10Y inversion below in red with subsequent drops in the SP500. Recession typically begins around 6 to 12 months after the yield curve inversion and the bottom of the stock market around 2 to 2.5 years after inversion followed by a rapid recovery...

The US 10Y/2YR yield curve chart, at least when inverted, has a strong negative correlation with the SP500. As this inversion curve moves up we can expect the SP500 to move down (and vice versa)...

Hard Landing vs Soft Landing: SP500 after rate cutting cycles since 1984

Any moves down in the SP500 after (or just before rate cuts) will need to see buy the dippers pushing the market back up. If we don't see this then the probability for a hard landing and stock market sell-off increases...

Percentage of Inverted Yield Curves

Another excellent long term indicator of recession and therefore stock market declines in the percentage of yield curves that have inverted (2y to 10y, 3month to 2Y etc). It has never been wrong at predicting recession but the recession occurs typically appears about a year or so after and there could be stock rises before the real declines are set in motion.

Length of Time Inverted

The graph below shows the relationship between the length of time inverted and the resulting drawdown in the SP500. The message is clear. The longer the inversion the greater the drawdown/crash. We are currently in 2024 at similar levels to 1929. That's not to say that we are going to see another 1929 as there are a lot more measures i place to stop such a mega-crash from becoming a reality, but something more like 2008 is entirely possible... -50% to -60%.

10Y and 2Y US Government Bonds Inversion

The chart below re-iterates the importance of US Treasury 2Y 10Y yield curve inversion. It has not been lower, or more negative in the last 40 years. i.e. lower than in the GFC 2008 and in the tech crash of 2000

Economic confidence and interest rates are reflected in the 10-year and 2-year US government bond yield rate. In 2022 these started spiking as central banks increased interest rates to combat runaway inflation. This was the main driver behind stock market declines.

When we see US bond yields spike as they did in 2022 it's bad news for our globally diversified equities funds and bond funds. High yields need to come back down to earth to support both equities and bond prices.

These two yields accurately predict recessions when they are 'inverted' (2 year yield higher than 10 year yield). As you can see in the image below this 'yield curve inversion' has predicted every major recession going back to the 1970's, and has happened once again in 2022 increasing the likelihood of recession at least in the US and by osmosis, in other countries and developed markets.

The Trading Economics graph allows you to select different bond duration charts and switch to the 'forecast' tab to apply a statistical forecasting model pointing to the future direction... nice!

It should also be noted that the general level of the 10 year yield is also something to watch out for regardless of an inversion... A good general rule of thumb is that if the US 10 year treasury yield hits 2.25% and keeps going up... it’s a warning flag pointing to falling stock markets.

US GOV BONDS GRAPH

The circled highlighted 'inversions' below are all followed by grey shaded areas which are recessions. The effect on inflation (the blue line) is also highly predictable. We are also seeing that inflation contraction that also preceded recession. THE RECESSION WILL LEAD TO A DROP IN GLOBAL STOCKS AS THE MARKET RETURNS TO BUST/RISK-OFF accompanied by contagion and fear based selling of stocks. Rotation into government bonds as the 'flight to safety' asset of choice is usually seen when this phenomenon starts to gather pace.

Yield Curve Inversions Lead to Disinflation

Inflation (the blue line) can quickly reverse into Deflation once the yield curve inverts...

In both the Dot Com crash and the Great financial crisis (2008/9), the Federal Reserve paused rates at the top of the hiking cycle and then when they pivoted down, the real declines in stock markets were realised as earnings declined and recessions kicked...

If you plot the Fed rate against the 2Y Treasury yields, before the 2001/2008 recessions, there was a decisive move down in the 2Y yield which was then followed parrot fashion by the Fed. In both cases the grey recession bars appear on the chart about 3 to 4 months after the Fed cuts.

(The 'taper tantrum' 2017/19 was similar, but coming down from lower rate levels than now and 2008, but then Covid came along and hammered both rates down to zero.)

What we are seeing now on the chart looks like a carbon copy of 2008 GFC... exactly the same Fed rate level and length of pause. A similar topping pattern and length of that topping pattern in the 2Y yield... and then a decisive move down. The big question of course now is "is it different this time?" The Fed says it is... we shall see in just a few months according to those charts.

STOCKS TO BONDS PERFORMANCE

Related to the above, at the start of major downturns in stocks we see extreme out-performance of stocks just before bonds make their comeback. In particularly after long yield curve inversions as we can see below. The 2024 'Everything Bubble' is a prime candidate for the next downturn...

How Central Banks and Central Bank Interest Rates Create Booms & Busts

How Central Banks Create Inflation via the M2 Money Supply

This is essentially a measure of the amount of money creation. This represents the amount of money chasing goods and services in the US economy. As you can see the chart has accelerated exponentially after the Coronavirus pandemic (...read… INFLATION!)…

Click below to open up a new tab to see the latest graphs.

M2 MONEY SUPPLY

Related to the M2 Supply above is the M2 Monetary Base which represents the Total amount of liquid money in the system: –

M2 BASE

Yield Curve Inversion Predicts Bear Market

The 20/30 year US Bonds have inverted whereby the 20-year bond yield is higher than the 30-year bond yield. This is known as a ‘Yield Curve Inversion’ and is an accurate bear market indicator. The last time this happened was around 2009 at the time of the GFR (Great Financial Crisis). In terms of timing, recessions are likely from up to 2 years after a ‘Yield Curve Inversion’, so it doesn’t happen overnight. However, it could well happen before that in this case.

Let the Taper Commence

Central banks are about to start tapering and possibly raising interest rates at the same time. In 2018 when they last tried this it caused a stock market correction. The ‘Taper Tantrum’. (Look for US Tech (QQQ) to start selling off on the first signs of interest rate rises.)

The plan is for a $10-$15 billion per month tapering program starting in November 2021. This is quite rapid leading to an end of the QE program by mid-2022.

The 2018 ‘Taper’ saw the Fed reduce its QE program by $10 billion every 3 months, stopping at $30 billion per month. The current proposal is more aggressive. This previous attempt to taper a major QE program blew up the debt markets which triggered stocks to collapse 20% in just weeks.

Central Bank Stimulus

The links below record the current 'assets' on central bank balance sheets. This is a measure of the amount of money creation (money printing) they have been engaged in.

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