I have a belief system. I believe interest rates matter. I believe policy lags exist. I believe the business cycle has not been repealed. And I believe in the power of the yield curve since, after all, it has a perfect track record.

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David Rosenberg: What comes after a peak yield curve inversion? Nothing good Back to video

Let’s talk first about interest rates, the United States Federal Reserve, and the economy. Historically, the best year of the economic cycle is the year the Fed first begins to tighten policy. That is the sweet spot, and in an effort to try its best to smooth the cycle, the Fed is hiking rates just as the economy is feeling the positive lags from the previous period of policy accommodation.

In the initial year of a Fed tightening phase, real gross domestic product growth averages 3.5 per cent and the median pace is 3.4 per cent. The mode is three per cent. Never before, until this cycle, was it below 2.2 per cent. And then, in the 2022 tightening phase, real GDP growth did what it has never accomplished, which is to come in at a mere 0.9 per cent on an average quarterly basis. That is because of all the COVID19-related distortions this cycle, from the lockdown-induced surge in goods expenditures and free stimulus to checks to all, that made 2021 a huge boom. The reopening trade also served up a huge bolstering effect on economic activity.

But the fallout is that too much growth was front-end-loaded this cycle, so there isn’t much left in the tank. For all the talk of economic resiliency, the reality is that average quarterly real GDP growth in the U.S. ran at a stall-speed of less than one per cent through the entirety of 2022, and real final private demand completely stagnated in the final three months.

Remember, the lags of what the Fed did in 2022 will show the peak dampening impact on the economy in 2023. And everything the Fed is doing now and into the summer will exert its peak impact into the first half of 2024. There is no turning back on this front.

The question becomes what typically happens in the year that follows the first year of the Fed tightening cycle. Not once in any cycle back to 1959 did the economy fail to slow down, and the average haircut to real GDP growth is 260 basis points.

The problem with having the baseline growth rate at a puny 0.9 per cent heading into the second year of this Fed cycle is that there is no margin of error. A typical haircut leaves real GDP growth by this time next year running at -1.7 per cent. That’s the average. The median trimming is 200 basis points, so on this basis, we would be talking about -1.1 per cent. All that is left to discuss is when the recession officially begins, and the timing is up in the air, but between the shape of the yield curve, the pattern of real M2 money supply, and the Conference Board’s Leading Economic Index (LEI), it’s very likely Q2 or Q3 of this year.

If nonfarm payrolls and the unemployment rate lag the cycle, with the former peaking into the early months of the downturn and the latter bottoming in the early stages, it wouldn’t be the last time. The fact that the Fed is chasing lagging indicators will only ensure that the recession is deeper and lasts longer than would have been necessary. But all in the name of underpinning the perceived loss of Fed credibility and ensuring that the inflation genie is placed back into the bottle for good.

Now let’s delve into the yield curve. The bellwether 2s/10s curve is now going into its ninth month of inversion. The average for all the prior cycles over the past five decades is nine months and the median is eight months. We are destined to surpass these. The peak inversion, on average, is -75 basis points and we are now at -90 basis points. We are essentially at or near peak inversion in both duration and magnitude. And the question is: what comes next?

In the year after the peak inversion, here is what has typically happened. The recession becomes a lock and that takes the yield on the 10-year T-note down 75 basis points. The two-year yield plunges closer to 200 basis points, because guess what? Six months past the peak inversion, the Fed is swinging from tightening to easing. That is the nature of the interest rate and economic cycle.

As for the S&P 500, from the time of the peak inversion of the curve to the market lows, the index is down an average 23 per cent (median of -17 per cent). Only when we are 70 per cent of the way into the recession and Fed easing cycle, and only when the central bank has pivoted enough to push the coupon curve into a positive slope, is it safe to start shifting the asset mix into an overweight position in favour of equities.

That could be a year away, and it means that all equity market rallies, as we saw so many times in 2022 and in January of this year, are bear market rallies to be rented, not owned. Our just-released Strategizer scorecard for the S&P 500 declined precipitously and the recommendation for duration exposure to take advantage of the yield overshoot in Treasuries became more entrenched. The year that follows the peak curve inversion means bonds over stocks, a barbell over bullet approach to Treasuries, and move up in the quality curve within the universe of corporate credit (spread product in general).

David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. You can sign up for a free, one-month trial on Rosenberg’s website.

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