It looks like 2022 will be full of challenges for the global economy and financial markets as economic growth expectations have fallen dramatically and the prospects for an economic recession have increased. Traders now change their question from will be an economic recession to when will the recession occur in 2022 or 2023?
At the end of March, there was a reversal of the yield curve, with two-year yields rising to a value greater than 10-year yields, which means that buying government bonds in the short term for two years gives a higher return than buying government bonds over 10 years, indicating that economic recession is only a matter of time. According to MUFG Securities, the yield curve inverted 422 days ahead of the 2001 recession, 571 days ahead of the 2007-to-2009 recession, and 163 days before the 2020 recession.
On Wednesday, April 6th, the Fed announced its intention to cut its budget; Fed meeting minutes reveal the Committee’s interest in starting quantitative tightening (QT), which is allowing the balance sheet to contract and doing QT much faster than the previous round of QT in 2017-19. Federal Reserve’s bond holdings could decline by as much as $95 billion a month, but this would not happen for a few more months as this plan gets phased in. They proposed shrinking the Fed’s balance sheet at a maximum monthly pace of $60 billion in Treasuries and $35 billion in mortgage-backed securities. It nearly doubles the peak rate of $50 billion a month, the last time the Fed trimmed its balance sheet from 2017 to 2019.
If you want to expect the impact of all these adverse events on the markets in the future, we need to have a flashback glimpse to see the impact of the reversal of the yield curve and the reduction of the Fed's budget on the markets. Since 1955, equities have peaked six times after the start of an inversion, and the economy has fallen into recession within seven to 24 months.
Does this mean that you have to get out of the stock markets directly after a reversal in the yield curve? The answer will be “No” if we notice the table below. The stock market is expected not to fall immediately after the reversal but needs a period of time before a top is achieved and a decline occurs.
The chart shown below shows the performance of the SP500 and the performance of different sectors and the performance of oil and gold in the period between the inversion of the yield curve and the stock market top between December 2005 to October 2007. The oil and energy sector performances were the best during this period, followed by the gold and the raw materials sector.
The chart below shows the performance of the SP500 and the different sectors and the performance of oil and gold between the yield curve inversion and the stock market top between August 2019 to February 2020. The best performers were in the technology and financial sectors.
The period between 2005 and 2007 is the closest to the current economic conditions, so this period can be used to predict the performance of stocks and sectors in the coming period. The chart below shows the markets' performance since the yield curve's reversal at the end of March this year.
The Fed cut its budget before in 2018, and the market has suffered from reduced liquidity, as the chart below shows.
The chart below shows the performance of the SP500 and the different sectors and the performance of oil and gold during the Fed phase by reducing its budget where we see strong fluctuations during this period, which makes us expect a lot of volatility in the markets during the coming period.
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