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Highest yield curve inversion

Matein Khalid

Don’t fight the Fed is a Wall Street cliché that makes total strategic and tactical sense as America heads for Turkey/cranberry sauce this Thanksgiving. While the S&P index is up 12% since its October low on euphoria over a CPI dip, hopes (misplaced) of a Fed pivot, a fall in the 10 year US note yield to 3.77% and a 4% drop in King Dollar. This is a bear market rally that will end with a failure at its 200 day moving average, exactly as did its predecessor in July at 4300. Why?

The yield curve inversion is now the highest since the 2008 GFC as the 2 year Uncle Sam note trades at 4.56% and thus implies a 2/10 UST inversion of 76 basis points. In essence, this is a recession SOS for 2023 that is far more ominous than what is implied by corporate credit spreads and the Volatility Index which has now sunk to 21.74 (nuts). I simply cannot justify new buying when Wall Street’s pendulum of greed and fear flashes a green light while the Treasury bond yield curve screams a scary crimson.

In any case, the S&P 500 Index is no longer cheap at 17.4X forward earnings and an equity risk premium of only 190 basis points at a time when geopolitics, economic/earnings risk tell me it should revert to the past decade average of at least 400 basis points. Above all, the smoke signals from the Powell Fed make it clear that they have a zero appetite for a pivot now or at the December FOMC while analyst earnings are at least 20% too high for this stage of the business cycle.

In a recession scenario, I entirely agree with Morgan Stanley equity strategist Mike Wilson, who alone called the market right in 2022 that index EPS in 2023 will fall to 195. If so, the S&P 500 is now trading at 20.50X and the equity risk premium is at a dangerously low level of a mere 110 basis points. This means there is no room to hide at this point in time and while humpty dumpty is sitting on the wall but is overdue for a great fall.

The Fed has made it clear that it wants tighter financial conditions in risk assets and much weaker housing/labour/credit markets. Yes we will see a 50 basis point FOMC rate rise next month and a pause in early 2023 but there is zero chance of any premature Fed pivot in 2022 unless Putin announces that he is willing to sell Russian crude for free as a Christmas gift to a world economy he has done so much to destabilize with his Ukraine invasion.

Powell’s “inflation is transitory” policy error in 2021 caused the inflation nightmare he has to fight now with credible monetary tightening and once bitten, twice shy is a recurrent theme in the folklore of modern central banking. Monetary policy works with time lags and the Fed will want to make sure that inflation is down “decisively and sustainably” before it signals a pivot and this simply will not happen in 2023. So the twilight zone between a final rate hike at say the May FOMC and a rate cut in early 2024 could be a period where Mr. Market is unsettled, angry and even paranoid. Caveat emptor.

Also published on Medium.

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