Inversion

TUE 08 AUG 2022

A key part of our process is to determine whether there is a divergence between price or consensus beliefs on the one hand and the fundamentals (facts) on the other. As we observed last week, recent deterioration in key leading indicators of the macro cycle has seen the prevailing bias shift from inflation risk to growth fear. As a result, a number of market participants had started to “hope” for a pivot from the recent trend of super-sized rate hikes by the Federal Reserve.

Although it is important not to place too much weight on one monthly data point, Friday’s US employment report will likely dispel any near term fear the Fed might have had about US underlying growth. While the looming CPI report tomorrow will also be important for near term expectations, the big picture point for markets is that the odds of even tighter policy, have increased. In turn, that is likely to contribute to further inversion of the yield curve and might lead to a new low in equities over the coming weeks or months as tighter financial conditions contribute to further valuation de-rating and the probable earnings recession.

No matter how you cut it, the US employment report on Friday was a strong number. Higher-than-expected job growth, wages, upward revisions and a sharp drop in the unemployment rate will dispel any near term concern the Fed might have had about underlying growth or macro conditions. Not surprisingly, short term interest rate expectations for year end 2022 moved back toward 4% and there was an aggressive re-pricing of beliefs in the fixed income markets. The 10-2 year yield curve is now -40 basis points and the most inverted since before the 1991 or 2001 recessions (chart 1). The probability of a proper profit recession have increased.