Rates vs markets, yield curve inversions

Rates vs markets

We are modestly defensively positioned.

However, it is worth keeping in mind that markets tend to do pretty well, in the early phases of a tightening cycle, an idea that holds across a range of geographic markets.

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And as shown below, specifically, for the US, ahead of tightening cycles.

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Yield curve inversions

The term spread captures bond market expectations. Steeply sloped spreads indicate strong expected growth, and/or expected inflation. Negative spreads indicate the expectation that growth is expected to slow, and that policy rates are likely to be cut, as such longer dated bond yields fall below shorter dated ones, causing inversion.

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It appears the Fed (tightening aggressively, but viewed as behind the curve and likely to trigger a recession as it slams on the brakes) is at odds with the RBA who is likewise late, but in no seeming hurry about it, which is causing the difference in term spreads.

Note that a flat curve isn’t a reason to panic, and often both growth and markets do just fine with flat curves. It’s inversion that counts. And even then, it can take up to a year for what inversion implies to manifest into weaker equity markets.

At the moment, probit models (which translates spreads into a probability of recession) do not indicate cause for concern.

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Conclusion

Now, we are concerned. That’s why we are modestly defensively positioned. Where we’ve deployed capital, we’ve done so into regions that fell a lot already (e.g. European equities post the 20% drawdown, similarly emerging market ETFs).

If they fell further, we’d allocate more capital, but the point is those trades didn’t suddenly indicate bullishness.

However, the above models, graphs and historical examples remind us that it’s not a slam dunk to be bearish, and that there are plenty of models that paint a rosier picture.

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