The European Central Bank (ECB) meets today to discuss markets and monetary policy, and we expect the ECB to lower rates by a quarter of a percent as they coordinate a global easing cycle with the Fed and most other central banks.
Christine Lagarde, President of the ECB, began cutting rates in June as the euro area showed signs of weakening growth earlier this year. The U.S. dollar will likely feel downward pressure as the Fed attempts to move in lock step with its European counterpart.
Weaker domestic growth and decelerating inflation metrics have put unique pressure on Treasury yields recently. Recently, the yield on the 2-year Treasury fell below the 10-year yield as markets expect — perhaps irrationally — that the Fed will cut aggressively despite some stickiness to inflation.
Yield Curve Often Disinverts Before Recessions
Fed Cuts Are the Catalysts
Source: LPL Research, Federal Reserve Board 09/10/24
Investors often talk about the recession signals from an inverted yield curve. Many debate the validity of this signal, especially since the curve has been inverted for quite a while. Perhaps the debate should focus on the drivers behind the inversion and — more importantly — the drivers behind the dis-inversion.
In discussing rules, signals, and theories, Fed Chairman Jerome Powell recently corrected market observers that these recession warnings are statistical regularities, not “an economic rule where it’s telling you something must happen.”
As it relates to the spread between 2-year and 10-year Treasury yields, the dis-inversion is a likely combination of three important factors. First, early signs of slowing economic growth have put downward pressure on yields. Second, markets are anticipating the Fed to aggressively cut rates. And third, the Treasury market continues to be a safe haven for global investors concerned about the greater risks internationally.
So what about the periods of dis-inversion? Note the mid-1990s. The Fed was able to cut rates with softer inflation and higher labor force participation. Still, the economy did not fall into recession because real disposable incomes were growing, giving consumers the ability to spend.
A Word of Warning
The U.S. economy did not fall into recession in the mid-to-late 1990s. The U.S. grew by 4.4% in 1997, 4.5% in 1998, and 4.8% in 1999, and domestic equity markets rallied. Growth was much stronger than expected given the international crises. However, international markets were experiencing something different.
In 1997 and 1998, the Asian financial crisis impacted international economies and spread to Eastern Europe and Latin America. The Fed responded with more rate cuts, easing some of the global pressures on domestic businesses and consumers. Part of the issues of that time were in the banking system and exposure to excessive hedge fund leverage, illustrated most famously by the collapse of the Long-Term Capital Management (LTCM) hedge fund.
Summary
LPL Research anticipates higher volatility among both bonds and equities during this period of global uncertainty and the softer growth outlook. Therefore, LPL’s Strategic and Tactical Asset Allocation Committee (STAAC) maintains its neutral stance on equities while watching for potential opportunities to add equities on weakness. We expect volatility to remain elevated over the next few months, and believe a better entry point back into the longer-term bull market will likely emerge.
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