No, It's Still Not Time to Panic Over the Yield Curve

A quick reality check on what this rare signal really means for the stock market

CMT, Senior Market Strategist
Mar 25, 2019 at 8:30 AM
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The doubt we had in the S&P 500 Index (SPX - 2,800.71) breakout manifested itself late last week, after the Federal Open Market Committee (FOMC) decided to hold rates steady at the conclusion of its meeting on Wednesday. As we mentioned previously, nearly all market participants had largely expected this result. However, the Fed did surprise by changing its forecast to zero expected rate hikes in 2019, when just a few months ago they were expecting as many as three rate hikes this calendar year. Additionally, they are only forecasting one rate hike in 2020, as they see headwinds from a slowing global economy and mixed domestic economic data.

"So, what does this mean for stocks in the short-to-intermediate term? Well, it turns out not much, at least for a handful of months or more. Indeed, an inverted yield curve has preceded the previous five recessions and will have market participants worried regardless -- but I'd like to point out that this popular recession indicator has been, on average, 15.4 months early over the last five recessions."
-- Monday Morning Outlook, July 23, 2018

On top of the Fed's outlook, the spread of the 10-year Treasury yield minus the 3-month Treasury yield curve inverted, which financial media used as an opening to begin once again stoking recession fears. I feel it's only prudent to quickly remind our readers that, as we discussed last summer, these fears are typically premature.

months to recession after yield curve inversionThe spread of the 10-year Treasury minus the 2-year Treasury yield curve is the one we should be watching -- and even when that inverts, which it hasn't, it still predates a recession by an average of 15.4 months. I'd also like to reemphasize that we'll see other signals to confirm a looming recession, such as the index of leading economic indicators turning negative (which has slowed, but still showing positive increases).

As we anticipated, markets continued to key on the SPX 2,800-2,820 area last week. The 2,820 level initially acted as support, but volatility started to kick in late Wednesday after the FOMC announcement drove an initial pop in the markets, followed by an eventual close lower. This set the stage for a surprise to the upside on Thursday after the pre-market was indicating a lower open, but instead, the market started a relentless march higher throughout the day.

Which brings us to Friday, when market participants who thought the Fed's dovish decision was bullish began to waver under global growth concerns and yield curve inversion fears. This led to panic selling as we cascaded lower right through the 2,820 level. A late-day attempt to rebound off the lows failed, and proved that the 2,820 level is now acting as resistance. The SPX eventually closed right on the 2,800 century mark, keeping intact a now eight-year trend that we discussed last week of a flattish-to-negative week after March options expiration, as the index shed -0.77%.

Moreover, the iShares Russell 2000 ETF (IWM - 149.62) has been diverging from the SPDR S&P 500 ETF Trust ETF (SPY – 279.25) and the Invesco QQQ Trust (QQQ – 178.56) over the past couple of weeks, with IWM putting in a lower high last week and finishing Friday's session down a whopping -3.64%. It's well known that small-caps often lead other major indexes in both tops and bottoms in long- and short-term time frames -- so while the Friday sell-off unwound some short-term overbought conditions, we're not necessarily out of the woods yet. Plus, the QQQ reached a 77.96 reading on its Relative Strength Index (RSI) last Thursday, a level we have not seen since January 2018, just before the February 2018 correction.

While we know overbought conditions can persist for quite some time, there may be some hesitation to bid growth stocks up amid the global growth concerns. This directly relates to the other reason we were cautious in last week's commentary, as we saw defensive sectors starting to perk up. The trend continued through last week; while healthcare finished down slightly, utilities and consumer staples finished strong -- up +1.69% and +2.03%, respectively. This sector rotation could continue into April, as Friday's price action likely spooked some market participants with cyclical sectors taking a beating.

Meanwhile, updated Commitments of Traders (CoT) data showed large speculators continued adding to their net short position on Cboe Volatility Index (VIX - 16.48) futures, while they've also been steadily covering their net short positions in the S&P 500 e-mini futures -- which tells us fund managers are starting to take a more bullish tilt as they attempt to play catch-up, since they've been lagging the indexes throughout 2019. Coincidentally, sentiment data from the American Association of Individual Investors (AAII) survey showed a sharp reversal in bearish sentiment, falling by -7.6% last week and pushing the 10-week moving average of pessimism below the fall 2018 lows. These contrarian indicators give us more evidence that the market might still have some downside risk over the next couple of weeks.

aaii 10-week ma 0324

It's not all doom and gloom, though; long-time readers are aware that the SPY has often been higher a month after the Fed holds rates steady. In fact, SPY has been higher after 75% of the 24 occurrences, with an average return of +1.26% and a median return of +1.98%. If this holds true, I expect we'll see the market resume its uptrend by early April, as the seasonality data suggests.

"To begin with, since 1928 we find that the market on average does rally from the beginning of March through the end of April, finishing positively +1.44%. Typically, March starts out flattish and slightly skewed positive. Historically, the market rallies mid-month before pulling back in the final week and finishing somewhat positive, around +0.55%. While we sold off by -2.16% to begin March, we have since reverted to the mean and are slightly positive, with a return of +0.67% on the SPX since the March 1 close."
-- Monday Morning Outlook, March 18, 2019

There certainly is potential for us to make another move lower this week, as we often drift south during the final week of March, according to the historical data that dates back to 1928. However, there is a decent amount of open interest at the SPY 275 and 270 put strikes that coincides with the 200-day moving average and the round 2,700 century level on the SPX, respectively. I fully expect the bulls will attempt to defend these areas if the SPX round century mark of 2,800 fails to hold today, setting up potential bounces at those support levels.

spy open interest by strike 0324

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