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Is the Yield Curve Indicating Economic Turbulence Ahead?

Capital Markets Perspective brings you what to watch in the markets this week, published in partnership with Great-West Investments.

Week in Review

March 21– 27

[Charlie:] “Well, Lieutenant, if you were directly above him, how could you see him?”

[Maverick:] “Because I was inverted.”

– Top Gun, 1986

 

Sorry, I couldn’t resist.

If you haven’t seen the 1986 movie Top Gun, I feel sorry for you. But if you have seen it, you might understand the reference: in the movie, hotshot fighter pilot Maverick is explaining to astrophysicist (and eventual love interest, Charlie), how he was flying his plane upside down in very close proximity to a Russian jet. Charlie is understandably skeptical because she finds it very unlikely that Maverick would have the necessary perspective to observe the Russian pilot during so bold a move.

Substitute “Jerome Powell” for “Maverick” and “The Market” for “Charlie” in the above and you have a fair representation of where markets are at right now.

Let me explain: the yield curve – basically the difference between US Treasury yields of different maturities – possesses almost mythical qualities for market practitioners. Ordinarily, it’s “positively-sloped”, meaning that longer-term yields are usually higher than shorter-term yields. That makes sense, because when you loan money to someone for a longer period of time, it’s reasonable to expect a higher return as compensation for having your money locked up for longer.

But sometimes, that relationship goes into reverse – becomes inverted – with short-term rates somehow ending up above longer-term rates. Typically, that only happens during times of economic stress. In fact, when the yield curve “inverts”, one thing you can count on is that CNBC, Bloomberg, and just about anyone else who comments on markets will start using the “R-word” (recession.) That happened again on Monday, when the difference between 5-year and 30-year US Treasury yields flipped upside down, at least for a brief moment.

So hotshot fighter pilot Jerome Powell has done more or less what Tom Cruise’s Maverick did in the movie: he’s flipped his F-15 upside down in very close proximity to a Russian antagonist. Meanwhile, markets (which we have substituted here for Kelly MacGillis’s astrophysicist Charlie) are skeptical that he has the proper perspective to pull off such a maneuver: does he, Powell, have a clear enough view of what’s going on in the economy to brave flipping the yield curve upside down without courting disaster? Or, is he pushing so hard on the throttle of rate increases (and such) that he’s risking pushing the economy into a flat spin from which it won’t recover?

In the movie Maverick has prospective to spare and things turn out just fine (unless your call-sign is Goose, but I’ll save that for another day). In fact, Maverick and Charlie even end up as a couple. But leaving aside the obvious parallel of the love interest between markets and Jay Powell, the final scene of this version of the drama has yet to be written. But for now, markets aren’t too panicked by Powell’s bold move (which, for the record, came in the form of assurances that the Fed would boost rates by half a percent instead of just 0.25% if inflation didn’t start behaving itself soon[1]). As evidence of that confidence, you really don’t need to look much farther than equity market returns, which were mostly positive last week even as Powell was pulling off his daredevil aerobatics (and despite the continued tragedy in Ukraine). Moreover, corporate credit spreads haven’t (yet) followed US treasury yields on their dramatic climb higher, further evidence that markets believe Powell’s wings are – at least for now – made of gold.

Whether or not the recent curve inversion means economic turbulence lies ahead is therefore debatable, especially since other, more closely-watched segments of the yield curve remain exceptionally flat but still upright. But upside-down is still a pretty unusual flight profile for both yield curves and F-15s and, at a minimum, this whole episode suggests that some kind of re-orientation is definitely happening inside markets and the economy. Stay tuned.

Of course, one of the reasons that Powell might be feeling bold enough to allow any portion of the yield curve to invert is strength in the labor market. Last week we got more confirmation of exactly how strong when the Department of Labor released its latest weekly count of how many Americans had filed for first-time unemployment benefits[2]. The number, 197,000, was only the third time this century below 200,000 (and only the 79th week in the whole history of the series, which dates back to 1967.) Notably, all three recent examples below 200k have come in the last 12 months.

And then there were the PMIs. Last week’s “flash” (that is “preliminary”) read of Markit Economics’ purchasing managers indices benefited from an end-of-omicron snap-back in services to beat most economist estimates[3]. What’s more, backlogs continued to expand, which might suggest that new business is driving results, rather than just a catch-up from past increases in demand. To be clear, though, it wasn’t all sunshine and roses: costs are still rising at a near-record pace and optimism among respondents slipped further as they acknowledged the role that the Ukraine invasion is beginning to play by extending the supply chain stress originally wrought by COVID but once thought to be improving.

And another segment of the US economy that is definitely not seeing things through mirrored, rose-colored lenses is the consumer segment. Last week’s final read on March consumer sentiment from the University of Michigan slipped even lower than the mid-month read a few weeks ago, and inflation gets most of the blame[4]. In fact, respondents cited an erosion of their personal living standards owing to higher prices more often than at any other time except “during the worst recessions in the past 50 years…” (namely, during the period between 1979 and 1982[5].) Meanwhile, a record number of consumers – 32%– expect their personal finances to worsen over the next 12 months – and the data goes back to 1944! (The one and only area of the economy where consumers still seem confident, however, remains jobs; on that, Powell and consumers can agree.)

So the current environment is one of extremes. Unemployment claims are at or near the lowest levels since the Vietnam War, while inflation has made consumers about as pessimistic about their personal finances than at any point since the Second World War. Meanwhile, we have a Fed Chair forced into performing all sorts of aerobatic moves by the highest inflation this generation of consumers has ever seen.

Bottom line, then, is that we should hope a happy ending for this episode, too.

What to Watch This Week

March 28 – April 2

Notable economic events (March 28– April 1)

Monday: Dallas Fed, business inventories, Biden budget

Tuesday: Consumer confidence, home prices (x2), JOLTS

Wednesday: ADP payrolls

Thursday: OPEC meeting, Weekly jobless claims, Challenger layoffs, income and outlays

Friday: Non-farm payrolls, ISM/PMI manufacturing

Ordinarily I’d probably spend the next few paragraphs writing about the labor market. After all, we get the Department of Labor’s job openings/leavings/turnover survey (aka “JOLTS”) on Tuesday, ADP’s national employment report (Wednesday,) Challenger Gray and Christmas’ layoff report (Thursday) and “The Big Burrito” – non-farm payrolls – on Friday. Toss in Thursday’s weekly initial claims report and that’s a LOT of opportunities to see how strong the jobs market is (or isn’t.)

But we all know that story. Even consumers, who by some measures seem to think the economy is essentially collapsing around them, admit that it’s a great time to be looking for work. So without some kind of shocking development that causes the jobs market to suddenly implode, we can probably forego too much discussion of jobs for the time being.

Let’s instead focus on a few other items that usually get less attention, starting with Thursday’s income-and-outlays report. It’s somewhat unusual for income and outlays to fall during the same week as payrolls, but that doesn’t matter too much because payrolls usually pushes it out of the spotlight anyway. This time, though, Thursday’s report might be more enlightening than Friday’s jobs data because it includes data on three things that matter most to the economy right now, namely: how much consumers are earning, how much they’re spending, as well as how much prices are rising (that last bit in the form of the so-called PCE price index, famous because it represents the Fed’s favored measure of inflation.)

But for my money, maybe the most interesting thing on the calendar this week is Thursday’s meeting of the OPEC oil cartel[6]. If you own or drive a car, you don’t need me to remind you that one thing keeping consumers in such a foul mood are gasoline prices. Because oil prices represent about 70% of the underlying price of a gallon of gas[7], what OPEC does on Thursday at its regularly scheduled meeting to talk about production quotas could have a pretty significant impact on a lot of what is keeping economists awake at night. The cartel has so far treated the Ukraine situation with a sensitive touch, likely out of fear of upsetting one of its advisory members, Russia (which is maybe the biggest “plus” part of “OPEC plus.”) Thursday’s meeting could provide OPEC with an opportunity to revise its approach, assuming it’s brave enough to risk ticking off its Russian semi-member by calling it to task on Ukraine.

That, plus any incremental news on what might become of Putin’s invasion as it enters its second month, could be the most impactful set of things on tap for this week. But since this is nominally a series about the economy (and 80s-movies trivia, apparently…) we should probably at least note a few of other things, even if they are less controversial than the suspiciously-delayed release of Top Gun II (which was supposed to hit theaters two and a half years ago).

Examples include two separate reads of home prices (yawn…high and rising, even if decelerating a little) and manufacturing PMIs (yawn…high, but pressured by labor, supply chain stress, and probably close to peaking.) Somewhat more interesting – but also not likely to surprise too many people – is President Biden’s budget, which should be released early this week. Look for that document to include an update of Biden’s economic priorities, even if some of them aren’t very likely to become actual national priorities when all the sausage-making of public policy is finished.

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Personal Capital Advisors Corporation (“PCAC”) is a wholly owned subsidiary of Personal Capital Corporation (“PCC”), an Empower company. PCC and Empower Holdings, LLC are wholly owned subsidiaries of Great-West Lifeco Inc. Source for index data: Bloomberg.com; GWI calculations.

 

[1] https://www.federalreserve.gov/newsevents/speech/powell20220321a.htm

[2] https://www.dol.gov/ui/data.pdf

[3] https://www.markiteconomics.com/Public/Home/PressRelease/ceb16fda72394fccad812e351f89d8df

[4] http://www.sca.isr.umich.edu

[5] Ibid. Notably, though, some observers feel that the 2008-09 recession was more impactful than the twin recessions in the early 1980s.

[6] https://www.opec.org/opec_web/en/publications/4580.htm

[7] https://www.stlouisfed.org/publications/regional-economist/october-2014

Thomas Nun, CFA, is a portfolio strategist for Great-West Investments.
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