July 8 2022
Politics have certainly been at the top of the agenda this week, with the resignation of Boris Johnson being the focal point. As should probably be expected however, the investment market response has been fairly muted. There was some sign of sterling strength following the announcement but markets soon reverted to business as usual.
Last week we reported an apparent change in rhetoric in terms of the inflation versus growth debate and this has extended into this week. Concerns regarding economic growth continue to build and that has been reflected in the shape of the US Treasury yield curve.
This week we have seen another inversion in the spread between the 10 year Treasury yield and 2 year Treasury yield. This comes in close succession to the one witnessed earlier this year. The spread between the 5 year and 2 year Treasury yield has also turned negative. With the US Federal Reserve focussed, for now at least, on bringing inflation under control by hiking interest rates, short tern yields remain elevated. Concerns over growth and that the expectation that inflation will indeed come off its current highs quite quickly for now is capping longer term yields.
Whilst the inversion of the yield curve does not cause a recession, historically it has certainly served as a strong predictor. The inversion of the US 10 year and 2 year yield curve has preceded the last eight recessions and ten out of the last thirteen.
Concerns over growth are giving rise to a large disparity in interest rate expectations when comparing the latest market forecasts and the latest edition of the Fed dot plot. Forecasts for the end of this year are relatively in line. Looking to the end of 2023 however it is here that we can see that differences arise. Fed Fund futures currently show a rate of c. 2.75% for the end of next year, 1% lower than the median expectation from Federal Reserve members. This suggests the market believes that the central bank will need to reverse quite quickly some of the monetary tightening which they will have put in place.
Very quickly we appear to have moved from an environment where the Federal Reserve was being criticised for not doing enough and ‘behind the curve’, to one where they are doing too much. There appears to be no happy medium, perhaps a signal of how quickly things can change and the volatility we should expect to see moving forward. Volatility can bring opportunity and to quote David Rolfe, “Volatility is a dear friend of the active, patient, value-sensitive investor.”
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