A funny thing happened this past week that got little mention by the financial media, whereas I thought was a particularly important and bullish development. The spread on the 2/10 Treasury note narrowed from retesting the historically wide spread of 110.9 set back in March. At the beginning of the holiday-shortened week, the spread was around 109.6 on Monday. By Friday’s bond market close, the spread had tightened to 0.88, a stunning move that should brighten the economic outlook if the trend continues.
What has the recession bears so convinced is that the wide gap of the 2/10 spread proceeded the recession in the early 1980s, triggered by extreme inflation that had to be corralled with surging interest rates. In 1980, the Volcker Shock raised the Fed funds rate to its highest point in history to end double-digit-percentage inflation. That was an extreme time for those of us that remember well how it impacted our lives. Thankfully, the inflation dragon looks like it will be tamed much earlier this time around. However, it will likely remain embedded in the cost of shelter, labor and professional services for years to come.
It was almost exactly two years ago that the 2/10 spread was at zero. And prior to July 2021, the yield curve was fairly normalized where the 2/10 spread hovered in a 1.0-1.5% range. If the bond market starts to raise its confidence that the economy can skirt a recession with GDP staying above 2%, then there is some real structural progress that can be made for bringing yields back into alignment that reflects steady growth and lower inflation going forward.
‘The Golden Path’
Considering the angst and hand-wringing that has been stressed by ardent recession bears, I’m surprised this sudden move went somewhat unnoticed. Maybe some of the relief came from newly-appointed Chicago Fed President Austan Goolsbee when he commented last Friday in a CNBC interview that he does not disagree with his fellow U.S. central bankers that rates need to rise a couple more times this year to beat back too-high inflation. “I haven’t seen anything that says that’s wrong — that is on the golden path of bringing inflation down to 2% without causing a recession. That would be a Fed triumph and that can involve a couple of rate increases over this year.”
In a headline-driven market, that statement struck a chord with bond traders, and though Goolsbee is a card-carrying cheerleader for the Biden administration, the market welcomes any Fed-speak that talks down recession. In the 2020 general election, he co-chaired the Economic Advisory Council for the Joe Biden Campaign. It would seem that Mr. Goolsbee might have his own “golden path” laid out to become Fed Chairman when Jerome Powell retires the position, and/if Biden is re-elected.
Whatever the case, despite the market enduring a week of pre-earnings season consolidation where 10 of 11 sectors closed in the red, it is my view the big bump in the 2/10 spread late Thursday and Friday is significant for the bullish trend for stocks in that it provides a fundamental catalyst coming right into the Q2 reporting season. And last week’s market price action of backing and filling was, again in my view, constructive for the rally to continue on. Oddly enough, real estate was the only sector that gained on the week, but it looks like a good set up for the broad market technically.
The market could be viewed as being at a crossroads. The yield curve is moving in the right direction, the dollar is trading lower as the appetite for risk is on the rise, gold prices are lower as investors opt for higher yields to fight inflation and commodity prices are holding steady with a much-improved global supply chain contributing to predictably lower inflation ahead.
It remains too early to make any sort of macro call, but in addition to the kick of earnings season, investors will receive key inflation data in the form of CPI and PPI this week, plus Friday’s UMich Consumer Sentiment report. Some good news on the inflation and earnings fronts will likely lead to a further flattening of the curve, and wouldn’t it be nice to go through a week not being reminded of the ugly inverted yield curve that results in a hard economic landing.
A rate hike in July looks fully priced in, but not one in September, where there is only a 24.2% probability of another hike. It’s a very fluid situation, but the economic glass is starting to look more half full than half empty.
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