Growth, XLE and the yield curve!
Something really interesting has just happened in the market. The reaction since Fed Chair Jerome Powell’s speech last week and the way in which the market rallied on the back of it…
Check out the chart below of the SP500.
He spoke on the 30th November, highlighted, and the market rallied up towards the 4100 mark.
This was off proposed dovishness (the Fed might hike by less going forward) but interestingly, the terminal rate didn’t change much whatsoever.
The terminal rate is the rate at which the Fed looks to end its hiking cycle at, and it is expected to be at 5% by May/June 2023.
Effectively, this means that even though the market rallied, we were in the exact same position as before Powell’s speech, which is largely why we are also back at the same price as pre-speech!
But what can we garner from this data point?
The 3 month - 10 year yield spread is flashing a warning sign!
The 3-month/10-year (3m10y) yield spread shows us the yield differential between the 3 month US Treasury bond and the 10 year US Treasury bond.
Very boring, but important!
If the longer end of the curve is being bought, it means people think that interest rates in the long run will be lower than where they are now (and it is why an inversion of this curve - when the yield differential goes below 0% - is a signifier of recession).
But we know the terminal rate didn’t change, so people are forecasting higher interest rates.
Why did the curve invert further then?
Well, the answer to this is that the market is now actively betting on a growth slowdown rather than making a bet on inflation as it had been doing.
And we can take some cues from the energy market on this…
XLE has had a wonderful year!
XLE, the energy ETF, had an excellent year - but recently, and more to our point about growth since the 3m10y curve inverted at the start of November, it has tailed off.
Expectations here are that a weakening growth environment is potentially going to cause some downside risk on this ETF, and specifically because it has been a very, very one sided trade through this year.
In a bear market we see sharp rallies as positioning becomes ‘heavy’, and a small catalyst such as a speech leads to short covering - but similar can happen in a bull market, where everyone is long.
In a macro environment where the Fed is hiking, it’s likely there is more volatility on downside moves as well with the energy sector, since the perception is the Fed actually wants to get the price of headline inflation down, which means less profit for energy firms.
Yield curve reversion!
Ironically, although the yield curve inversion is what signifies recession, the actual recession doesn’t occur until the curve has reverted (the spread turns positive again).
This means that in the near term (six months out), we are unlikely to actually see recession in our view.
Key for recession to take hold is going to be when the 3m10y spread is approaching 0, which from our estimates, isn’t going to be until Q4 2023.
But of course, much can change between now and then, and the timeline could be shifted forward by serious geopolitical shocks or liquidity crises!
Not investment advice. Past performance does not guarantee or predict future performance.