Light On The Horizon?
“We cannot quantify the future, because it is an unknown, but we have learned how to use numbers to scrutinize what happened in the past. But to what degree should we rely on the pattern of the past to tell us what the future will be like?”
Peter L. Bernstein
Against The Gods: The Remarkable Story Of Risk (1996)
Despite the historical volatility of third quarters in general,1 broader equity markets once again capped off the last three months “in the black.” And, in a major reversal from the second quarter, the often lagging, less tech-heavy Dow Jones Industrial Average led the way (S&P 500 +5.9%; DJIA +8.7%; NASDAQ +2.8%).
In another notable move, the yield curve began un-inverting—meaning the yield on longer-dated bonds began to exceed the yield on shorter-dated bonds, as is the norm in a stable economic environment—principally between the crucial 2-year and 10-year Treasury spread. We touched on the importance of this measure in a prior article, noting its power in predicting (or at least coinciding with) economic downturns. Without fail, an inverted yield curve (one where the yield on 2-year Treasuries exceeded that of 10-year Treasuries) preceded every recession in the last 50 years (Figure 2a).
In theory, there have also been no “false alarms” by this measure in the last half century; a yield curve inversion has always been followed by a recession, though the duration of time in between the first inversion and the official beginning of a subsequent recession has varied considerably, averaging 15 months but taking as long as 24 months (Figure 2b).
Needless to say, we are still in the very early innings of the current interest rate environment. However, the Federal Reserve’s recent decision to cut its headline policy rate (the Fed Funds Rate) by 50 basis points (or 0.50%)—perhaps signaling the start of a longer cutting cycle supported by tamer inflation—further establishes the trajectory of short-term interest rates. With unemployment remaining relatively low as well, hovering around 4%, it seems possible that the US economy could achieve the much discussed-but-seldom seen “soft landing” from the unprecedented, pandemic-induced spike in inflation and ensuing tightening of monetary policy.
The economy is not without its risks, however. While the unemployment rate continues to trend well below average (Figure 3), it has moved up from recent lows. On one hand, a weakening jobs market could raise concerns about the health of the broader economy, while on the other, employment conditions that look overly robust may dampen hopes of further Fed Funds rate cuts, which in turn could have a negative impact on equity market sentiment.
In this regard, the Federal Reserve must strike a careful balance by easing monetary policy to help keep a lid on unemployment, but not too fast as to risk reigniting inflation. For market participants, lower interest rates and a normalizing yield curve should be bullish for equities and supportive of bonds (particularly those with shorter maturities), though investors will want to keep a close eye on inflation and unemployment releases, along with Federal Reserve commentary and policy actions. While the proverbial “light on the horizon” is growing brighter, recent positive momentum will need to endure a bit longer before everyone can breathe a sigh of relief.
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1 Over the last 30 years, the S&P 500 has experienced average price gains of just 0.07% in the third calendar quarter with 11 periods of drawdowns (the most of any quarter), compared to average gains of 1.2%, 2.8%, and 5.1% in the first, second, and fourth quarters, respectively.