Economic Update
- The 2nd half of 2023 begins with no more certainty on the timing or severity of a business cycle change
- Consumers have proven more resilient than many economists expected, and while savings have eroded over the last year, the windfall of COVID stimulus still lingers
- Certain measures of yield curve slope are back to 4+ decades lows. In prior cycles, the peak inversion level has been followed by significant bull steepening over the next 12 months
As we turn the calendar on the first half of 2023, there remains little consensus on where the economy is headed and what the Fed will do regarding interest rate policy for the remainder of 2023 and beyond. The bond market is currently pricing for rate cuts in late Q1/early Q2 next year, which is essentially a call on when the business cycle changes, but market pricing for Fed policy has been very volatile so far this year. The U.S. consumer has remained resilient to this point despite high inflation and rising interest rates, befuddling many economists forecasting a recession to begin as early as last year. To be sure, a recession will almost certainly occur at some point in the future. Business cycles change, and the Fed is effectively trying to initiate such a change to bring inflation down closer to its target level. The bigger questions are 1) when and 2) how severe. The Fed’s efforts over the last 15 months have included 500 basis points (bps) of rate hikes and balance sheet reduction, but the downstream impacts on the economy are not instantaneous. The length of this lag varies by cycle and is inherently difficult to predict, but the economic impact isn’t zero. Corporate profits and profit margins have come under pressure, and interest burdens continue to rise. Consumer savings have been a boon for consumption over the last few years, thanks in large part to a deluge of stimulus during the pandemic. However, those savings have eroded over the last year, albeit at a slower pace than many expected and from a historically high base level.
Exhibit 1 tracks household liquid assets from quarterly data compiled by the Fed. It includes checking and currency, time and savings deposits, and money market fund holdings. As we’ve discussed in previous commentaries, liquid assets exploded higher in 2020 & 2021 amid pandemic-related Federal stimulus. This metric rose $4.7 trillion in those two years relative to average annual growth of approximately $400 billion in the decade prior to the pandemic. In other words, liquid assets grew approximately $4 trillion more over those two years relative to the historical average. Savings began to erode last year, falling by $115 billion in Q1 and down $519 billion since peaking in Q1 2022. However, consumers still have excess savings, which helps explain spending and, ultimately, inflation continuing to surpass expectations over the last year.
Exhibit 1
Historic Yield Curve Inversion
When the Fed begins a tightening cycle, it’s not unusual for the yield curve to invert. Most tightening cycles end in recessions, and rate hikes and other measures are meant to lower forward inflation expectations. This cycle is no different, even if inflation has proven to be more stubborn than Fed leaders imagined. The yield curve is effectively priced for forward short-term rate expectations plus a term premium. Much of the volatility experienced over the last two years can be attributed to regular market repricing for future Fed policy, particularly on the front-end and belly of the yield curve. The bond market has once again repriced for a more hawkish Fed in 2023, with fed funds futures currently priced for a 5.40% terminal rate, or 32 bps above the current effective funds rate with no rate cuts priced for this year. However, as noted above, the market is pricing for rate cuts beginning in Q1/Q2 of next year based on general expectations of the economy tipping over into recession, even if a mild one.
Amid the recent hawkish shift in near-term market pricing, the 2-year/10-year Treasury spread reached -111 bps on July 3, the most inverted in more than 4 decades. Another metric, the 3-month/10-year spread, is currently holding at -150 bps. As such, it’s a good time to revisit a topic discussed in the February Monthly Market Commentary (Current Market Themes section). Relatively few financial institutions have been actively investing in their bond portfolios over the last several months and have instead been more focused on strengthening their liquidity positions amid deposit outflow concerns. As such, investing any excess liquidity in short-term instruments may be appropriate (and prudent). However, managers should avoid basing such decisions on the absolute yields of cash and short-term investments relative to longer-term assets given the curve inversion. Put another way, why would I invest in a 5-year asset with a ~4.5% yield when I can stay short and earn north of 5%?
To answer this question, consider the following analysis: Exhibit 2 tracks the last three curve inversion periods using the 3-month/10-year Treasury spread. In addition to the trough inversion levels for each cycle, curve slope 12 months after that point is also measured. In each occurrence, the yield curve steepened significantly in the following year, and as shown at the right, it’s evident that each was a bull steepening with short-term yields declining faster than long-term yields.
Exhibit 2
Now consider a very simple comparison of two investment decisions. At the time that the yield curve was most inverted, one investor purchased a 3-month Treasury and the other a 5-year Treasury. The short-term investment is an average yield over the next 5 years assuming reinvestment in the same instrument at maturity. Despite having a higher initial yield when the curve was most inverted, the investor who instead bought the 5-year Treasury at that point earned a higher yield over the next five years. A more complex analysis would evaluate holding period returns and expand the list of potential investments, but this simple analysis does shine a light on forward yield curve analysis and the importance of making investing decisions based on more than just selecting the highest yielding asset at any given time.
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