While a lot of investors and market watchers see the 15% return on the & 37% return on the and conclude that the good times are back, I’m focused on what might happen over the next six months. Yes, there are indications that short-term conditions are positive, including labour, GDP and (just recently) housing, there are just as many indications that the long-term outlook is not nearly so positive.
It’s easy to focus on things, such as monthly durable goods orders and pending home sales if you want to create a daily market narrative (and I’m guilty of that from time to time as well), but I believe that only a handful of market signals are really necessary to get a pretty good handle on the macroeconomic environment. Lumber and gold are very clearly two of them, but today I want to focus on a few others that are just as important – Treasuries, inflation, debt and volatility.
Why these four factors specifically? Because if any one of them breaks, the market usually breaks. Last year, inflation hit its highest level in 40 years and both stocks & bonds broke. If market volatility spikes, stocks will almost certainly be correct. The Treasury market has traditionally been a reliable leading indicator of recession. While we have yet to meet the technical definition of recession in the United States, there are several markers already indicating that we’re likely to get there eventually.
Most of you already know about the predictive power of the . It’s been quoted often and says that when this spread turns negative, a recession is likely to occur within the next 12-24 months. This has happened leading to every recession over the past half-century.
The thing that sticks out to me here isn’t just the fact that it’s negative. It’s how it resembles the stagflation ‘70s and the struggles that the U.S. economy had in putting that period behind it once and for all. The 10Y/2Y spread was all over the place in the early 1980s because the effective Fed Funds rate was also all over the place. The FFR dropped more than 1000 basis points from peak to valley in 1981 after inflation had peaked, only inflation stagnated instead of coming back down. The FFR shot higher again and for much of the early 1980s that was this whipsaw effect that resulted in a double recession over the course of three years.