Back in 2018, JPMorgan flagged what the bank’s Nikolaos Panigirtzoglou called a “significant” development that seemed to underscore concerns the Fed was either headed for a policy mistake or else that late-cycle dynamics were taking hold.
“An inversion at the front end, i.e. between the 2-year and 3-year forward points of the 1-month OIS curve… is a significant market development, not least because it occurs rather rarely”, Panigirtzoglou wrote.
The bank then endeavored to determine, via an analysis of flows data, whether that was indicative of the market pricing in a policy mistake or an end-of-cycle dynamic.
Fast forward nearly two years and Panigirtzoglou is out with something of an update on that analysis.
“Last year’s disconnect between rate and equity markets started re-appearing in recent weeks as bond markets rallied strongly and yield curves flattened”, he writes, adding that although stocks have managed to recoup losses associated with the virus scare, “the 10y UST yield is only flat to the Fed funds rate, suggesting that the previous three month interval of positive yield curve slope has ended”.
After acknowledging there are a number of factors (e.g., portfolio rebalancing and technical flows) that could “blunt the information content” of that signal, he says those factors “should affect the front end of the US curve by much less”.
That brings us quickly back to the same discussion from 2018.
“We had argued that the inversion at the front end of the US yield curve, since it first emerged in April 2018 between the 2- and 3-year forward points of the 1m OIS rate, had been an important market signal pointing to downside risk for equity and risky markets more broadly”, Panigirtzoglou says, referencing the discussion mentioned here at the outset.
The visual just shows the inversion shifting forward to 1- and 2-year forward points, a state of affairs Panigirtzoglou cites as a reason he remained “cautious”.
“The lesson from previous cycles is that equity and risky markets are unlikely to see a sustained recovery while the inversion at the front end of the US yield curve persists”, he writes, before flagging the rapid un-inversion at the end of October as a possible sign that rates markets were beginning to price out the end-of-cycle dynamic in favor of faith in the Fed’s “mid-cycle adjustment” narrative and therefore a view that the cycle (and the bull market) may be prolonged after all.
Not surprisingly (in light of recent events), that proved fleeting. Doubts about the Fed’s narrative are creeping back in amid generalized concerns about the outlook for growth.
“However, this positive phase lasted only three months as the spread between the 1- and 2-year forward points of the US OIS curve shifted back into significantly negative territory during the last week of January”, Panigirtzoglou goes on to say, cautioning on the implications, as follows:
This implies that risk premia related to potential economic slowdown or end-of-cycle dynamics are likely re-emerging and the confidence that rate market participants have to the midcycle adjustment thesis is dented.
What could turn the tide back in the “right” direction, you ask? Well, simple: Things could get better in China. If, however, the situation deteriorates further (say, in the event the re-opening of industry leads to accelerated transmission of the coronavirus), the market’s faith will be commensurately shaken.
Ultimately, Panigirtzoglou’s message is straightforward. I’ll leave you with one last short excerpt from JPM:
In all, similar to 2018, rate markets are sending warning signs, creating renewed disconnect between rate and equity markets. For equity and other risky market investors, monitoring and understanding these warnings signs would likely be as important this year as it was during 2018.