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The S&P 500 closed up 9.1% for the month of July, while yields on US Treasuries climbed on the short end (inside of one year) and came down over the longer term. This movement in rates has caused a sustained inversion of the yield curve, where the 10 year is yielding nearly 24 basis points lower than the 2-year Note, which is currently yielding ~2.9%. This condion is typically brought about as the Federal Reserve is hiking rates aggressively to cool the economy to bring down inflaon, which is the case currently. By rising so sharply in July, equity markets are sending a signal of confidence in the Fed’s posion and its credibility in combang inflaon that we are somewhat skepcal of.
The longer-term rates decline as investors expect a slowdown in the economy and seek protection of principal, in a “flight to quality.” The shorter-term rates rise as a direct consequence of the Fed rate hikes. Under more normal conditons, this shape of the yield curve would tell a story of the collective forecast of market participants that the Fed will be very aggressive and tame inflation in the next few years. We do not think that is an accurate assessment at this time, since inflation is at levels unseen in the past 40 years, and the last time inflation has been this high, the Fed Funds rate was well into the high teens, certainly much higher than its current level of 2.5%. According to a mathematical model still widely used by economists (despite lots of chapter over the years to the contrary), the Taylor Rule, suggests that the rate should be closer to 10%, reflecting a large difference from the Fed’s current and projected position.
We see continued volatility driving markets as we head into the end of the summer, and a high probability that the bearish market sentiment that has been in the driver’s seat through 2022 is not finished with us yet. Nevertheless, for the long-term investor, we have a positive outlook. While there has not yet been a definitive declaration that the current economic downturn is an official “recession,” we see a strong probability that this will happen before the year is out. That we are in an economic decline is a fact beyond debate (we have had 2 consecutive quarters of GDP declines), and it is also a fact that the Fed has declared its strong commitment to doing whatever is necessary to control inflation. Since equity markets look toward the future, it is typical for equity markets to begin a bottoming process and start to move up, some time in advance of the declaration. Thus, while we expect more volatility, July’s rally could mark the beginning of that bottoming process.
If you have questions or concerns about the markets, please reach out to us, we are here for you.
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