Friday, August 4, 2023
- A busy earnings calendar for equities has largely been overshadowed by volatility in the fixed income market this week.
- Treasuries stole the spotlight after Fitch downgraded the U.S. credit rating from AAA to AA+, putting added upward pressure on yields. Longer duration Treasuries lagged and a bear steepener curve developed, creating a potential double bottom formation in the closely watched 10-year minus 2-year Treasury curve spread.
- Historically, curve spreads have bottomed before five of the last six recessions since 1980, although it took an average of 187 trading days after the bottom for the official recession to start.
- Equity market returns following a major bottom in the 10-year minus 2-year Treasury curve spread have historically been positive over the following 12 months. Smaller caps tend to underperform during this period.
Treasuries Steal the Show
While it has been a busy week of S&P 500 earnings, the fixed income market stole the show. Fitch’s downgrade of the U.S. credit rating from AAA to AA+ put Treasuries in the spotlight and exacerbated upward pressure on yields that are already facing increased supply, quantitative tightening, relatively resilient economic data, higher-for-longer monetary policy, and the Bank of Japan’s recent tweak to their yield curve control program.
Longer duration Treasuries are underperforming on the week, including the 10-year, whose yield is up over 20 basis points (bps) since last Friday. The jump in 10-year yields triggered a breakout above the March highs at 4.09%, leaving the 4.24%-4.34% range (October/November 2022 highs) as the next major area of overhead resistance. Momentum is also confirming the breakout, including a recent Moving Average Convergence/Divergence (MACD) buy signal and bullish crossover between the 50-day and 200-day moving average (dma).
Volatility on the front end of the curve has been less pronounced, as shorter duration Treasuries are more directly tethered to monetary policy—which remains a higher-for-longer theme. With benchmark 2-year Treasury yields trading nearly unchanged since last Friday, a bear steepener curve has formed as longer-term rates are rising faster than shorter-term rates. As shown on the right below, the recent steepening or dis-inversion of the curve occurred right at support from the March lows, forming a potential double-bottom in the 10-year minus 2-year Treasury curve spread. Technically, a breakout above the declining 200-dma would add to the evidence of the lows being set.
However, on a longer-term basis, and as you can see on the left side of the chart above, dis-inversions of the 10-year minus 2-year Treasury curve spread often precede recessions (and provide an even more timely indicator for recessions than the actual inversion). Curve spreads have bottomed before five of the last six recessions since 1980, although it took an average of 187 trading days after the bottom for the official recession to start. Only in March 1980 did curve spreads bottom during a recession.
How Do Stocks Perform After Curve Spreads Bottom?
Finally, we also looked at how the S&P 500, Nasdaq Composite, and Russell 2000 performed after a major bottom was set in the 10-year minus 2-year Treasury curve spread. While acknowledging the data is limited, returns over the subsequent 12 months have historically been positive for each index, although most returns track toward modest underperformance relative to historical 12-month returns during this timeframe. In terms of relative performance, the Russell 2000 has historically lagged its index peers, a common theme for small caps before the onset of a recession.
Curve spreads have recently steepened after finding support off the March lows, forming a potential double bottom on the closely watched 10-year minus 2-year Treasury curve spread. Technically, a breakout above the declining 200-dma would add to the evidence of the lows being set. While a dis-inversion of the curve often precedes a recession, the lag time between when curve spreads bottom and the start of a recession has averaged 187 trading days. Stocks have also posted positive returns over the following 12 months after a bottom in curve spreads.
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