When we witnessed a slight drop in the inflation figures last month, many felt we had already seen peak inflation.  The 8.6% inflation print (a new 40 year high) caused some concerns in the markets on Friday with Treasury yields hitting new multi-year highs and increased concerns that the Federal Reserve may tighten more than previously anticipated.  A rate hike is expected next week with many anticipating an increase of up to 75 basis points.

Many feel the Federal Reserve waited too long to raise rates during this cycle, while others feel the rampant inflation is caused by other factors such as hampered production and supply chain issues.  Inventories are building up all along the supply chain as retailers and suppliers hoard goods to be able to deliver more effectively to their customers.  “Just in time” inventory seems to be a relic of the past and a dream we hope to someday recognize again.

We are just now returning to the materials, energy, metals, food and commodities highs last seen in 2008. But rental costs and real estate prices are much higher than before.  Labor costs have been rising as well although productivity is on the decline.

With housing costs comprising over 40% of the Consumer Price Index, we expect inflation to moderate with mortgage rates hitting 12-year highs, mortgage applications dropping, and home sales slowing across the US.  It is likely however that commodity, agriculture, metals and energy prices will continue to increase. We are well below the highs seen in 2007 and 2008 especially after adjusting for normalized inflation.

Last week we detailed “The Anatomy of a Market Bottom” citing seven factors we follow. The video above covers some of these with particular emphasis on sentiment and CEO purchases. With increased concerns over interest rates and Federal Reserve action, it may be worthwhile to look more closely at the last few rate cycles to ascertain what the future may hold.

Leading economic indicators look weak including yield curve inversions.

The chart below highlights these yield curve inversions over almost fifty years.  For all but one of the periods in the chart below, these inversions of the 2- and 10-year treasury yields occurred while the Federal Reserve was still raising rates.  Upon seeing an inversion, the Federal Reserve has usually continued raising rates to keep the economy from overheating and enable a “soft landing”.  Rarely do we achieve this “soft landing” however as they tend to go too far in slowing the economy.

With the yield curve inverting in March, we may see a recession starting this year or next. These yield curve inversions lead to recessions very consistently but rarely before the market makes new highs. Market tops after yield curve inversions are attained within 9 months on average. Many feel the real issue is not the inversion itself but the unwinding from the inversion as the spreads start to widen again. A rubber band can be stretched for a while before it snaps back, and the yield curve acts somewhat similarly.

The end of Federal Reserve tightening, interest rate hikes and a period of bond market outperformance.

We are currently encountering interest rate hikes from the “Fed” and additional tightening as they are trying to shrink the balance sheet to temper inflation. As we have noted multiple times, the market tends to top AFTER the Federal Reserve is done tightening as they become more concerned about recession than inflation.

The chart below of the dot-com melt-up and bust is one exception to this rule:

The Federal Reserve had been tightening from mid 1999 through May of 2000.  The 30-year treasury yield peaked in January 2000 and the yield curve inverted in February 2000 prior to the final Federal Reserve rate hike later than year in May and the coinciding drop in Nasdaq 100.  We note the Nasdaq bottoming after peaking in March with a drop of 40% because it tends to be more severely impacted by rising interest rates. The Nasdaq rallied prior to the end of the year but could not exceed the highs obtained in March of 2000.

The period from the yield curve inversion in 2000 to the high of the Nasdaq was less than two months. The 30-year treasury yield continued to drop from its high in February 2000 and bottomed in June 2003 after the stock market bottomed.

Diversification into bonds during this period provided substantial protection for portfolios, but only after yields had peaked. The Nasdaq lost over 80% of its value from the 2000 high to the 2002 low while longer term treasury bonds appreciated by over 20%.  It is worth noting that investment into emerging markets, smaller companies and other good values outperformed bonds during part of this period as the selloff in the most expensive names of the late 1990s did not adversely impact everything. We want to stress diversification rather than market timing, because we do not anticipate being able to know when yields or markets have peaked.

We can get a feel for when we are close to a bottom or a top based upon the opportunities available and other factors discussed previously, but our timeframe is in months to years rather than days to weeks.  We want to invest in companies with substantial economic upside being sold at attractive values and make sure to diversify to reduce risk in portfolios for those investors who prefer less excitement than the roller coaster swings experienced investing solely in equity markets.

The chart below shows the period prior to and during the 2008 financial crisis:

The Federal Reserve had been tightening from 2004 through June of 2006.  The Yield Curve Inverted in February 2006.  The 30-year treasury yield peaked in April 2006 prior to the final Federal Reserve rate hike in June 2006 and the coinciding drop in Nasdaq 100. Again, we note the Nasdaq bottoming in July 2006 with a drop of 16.9% because this index tends to be more interest sensitive than others.

This sequence of events beginning with the inversion of the yield curve typically preceeds a new market high.  In this case we did not see the ultimate high until October 2007.  The 30-year treasury yield continued to drop from its peak in 2006 and bottomed in December 2008 prior to the stock market bottoming.  An investment in treasury bonds from the 2006 or 2007 peak in yields would have substantially outperformed the Nasdaq during this financial collapse as the “flight to safety” caused bond prices to spike as yields dropped substantially.

From the market peak in October 2007 to December 2008 when bond yields bottomed an investor could have achieved a 35% plus return from longer term treasuries while the Nasdaq lost over 45% of its value.  While we do not anticipate being able to time these types of events, we want to stress how diversification into bonds during potentially recessionary periods can help protect portfolios.

The chart below shows the period prior to and during 2020 pandemic, extending to the present:

This chart shows many of the same precursors. The Federal Reserve had been tightening from 2015 through December of 2018.  The 30-year treasury yield peaked in October 2018 prior to the final Federal Reserve rate hike in December 2018 and the coinciding drop in Nasdaq 100.  Again, we note the Nasdaq bottoming in December 2018 with a drop of 23.5% because it tends to be more severely impacted by rising interest rates.  The Yield Curve did not invert until May of 2019 however and stayed inverted until October of 2019.  The yield curve rubber band snapping back at the end of 2019 was the final piece of the puzzle in this sequence of events prior to the market high in February 2020 and the nasty drop during the pandemic.

This yield curve inversion timing was atypical in that all previous inversions over the previous 50 years occurred while the Federal Reserve was still tightening.  Again, these factors when considered together typically occur prior to a new market high.  The 30-year treasury yield continued to drop from its high in 2018 and bottomed in April 2020 while the stock market was bottoming.  An investment in treasury bonds from the 2018 peak in yields would have kept pace or slightly outperformed the Nasdaq during most of this period until the market topped in February 2020.

Owning treasury bonds rather than the Nasdaq from the market peak in February to the bottom in March resulted in a performance differential of approximately 37%. Again, we do not recommend trying to time these types of events.  Diversification into bonds during this period provided substantial protection for portfolios, however.

SIGNPOSTS OF THE DANGER ZONE:

Signpost 1 – The Beginning of US Economic Summer

This typically coincides with Federal Reserve tightening.  They start to raise the Federal Funds rate impacting the prime and other lending rates. At this point we are far away from a recession as the Federal Reserve is just starting to do what they can to slow the economy and avert runaway inflation.  Many feel the Federal Reserve acted too late in raising rates and tightening monetary policy this time around as the inflation genie was allowed out of the bottle.
  

Signpost 2 – Treasury Yield Curve Inversion – First sign of Autumn. 

This inversion with two-year treasuries paying more than 10 year treasuries is one of the most consistent and predictable indicators of an upcoming recession.  We sometimes see this inversion prior to Federal Reserve tightening.  If this occurs outside a tightening window, recession is much less likely.  During or after a tightening window we have never seen a yield curve inversion that has not led to a recession within the next 24 months over the last 60 plus years.  Market highs are obtained within 9 months on average after a yield curve inversion.

The 1973 -1974 period is the only period since the early 1960s where the market peaked before the yield curve inverted.  Unfortunately we seem to be repeating many of the same 1970s inflationary pressures forcing higher interest rates today.

Signpost 3 – Peak Yields Seen in the Treasury Markets

These peak yields can be seen before or after the yield curve inversion.  Prior to and during recessions, interest rates typically come down as the demand for “safe havens” increase.  During the inflationary periods prior to the 1990s it was more common to see peak yields after market tops and before recessions.  It is possible that we have already seen the market top prior to the recession based upon how the markets tended to act during the inflationary 1970s and 1980s.

It would be exceedingly rare to see peak yields in a recessionary environment in that most of these environments coincide with a flight to safety and government stimulus in the form of monetary and possible fiscal stimulus which tends to force interest rates lower.  At some point the focus will turn from the Federal Reserve fighting inflation and raising rates to focusing on averting recession and lowering rates. During the changing of the guard, it is likely the stock market will see new highs although not as likely as it has been over the last 30 years.

Owning bonds in a recessionary environment has helped to protect portfolios substantially over the last 40 years.  Yields have been declining steadily since the early 1980s.  It is not easy to call the cyclical top in yields.  We have already exceeded the peak yields from 2018 for 10 year treasuries and we are nearing the previous top for 30 year yields as well. It is likely the bond market will fail to push though this level at 3.43% for  30-year treasuries, but we seem to be breaking the mold we excesses in many areas this time around.

Signpost 4 – The Federal Reserve Stops Raising Rates announcing Autumn has arrived.

This has played out very consistently since the 1980s. The market tends to top after the Federal Reserve is done tightening as they become more concerned about recession than inflation.  One exception to this was the dot.com melt-up in 1999 and early 2000. The market topped in March of 2000 prior to the last rate hike in May, but this was only after the Nasdaq had more than doubled in less than a year.  Winter arrived early in that cycle, but it followed an unseasonably hot summer.

How do we want to position portfolios now?

We expect the more interest rate sensitive growth stocks to continue their underperformance prior to the peak in yields.  If we follow the signs of the 1970s and 1980s, it is possible the markets have already topped prior to achieving peak yields.  In this case, it may still prove beneficial to diversify into bonds after peak yields are obtained and we start entering economic winter.  As we have noted, it is after the peak in yields when diversification into bonds provides the most protection.

Will we return to a 1970s and 1980s scenario where the Federal Reserve becomes less concerned about the markets and the economy in the short run and pulls out the stops to put the lid on inflation?  Do they believe that supply chain issues are less of an inflationary concern? I hope our political leaders become more motivated to solve our inflationary issues by adjusting policy to increase production and productivity.  Hopefully we will see a multipronged solution rather than a singular one relying solely on the Federal Reserve.

                                                                                                                   Joe Franklin, CFP®
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