Banking crisis not over yet?, What does an inverted yield curve mean?

Chart of the week

The chart shows investor expectations for interest rates through July 2024. Blue are investor expectations as recently as two weeks ago and red are expectations at the end of last week.

Why this matters
Investors expect the Federal Reserve to raise interest rates and not to 5.5% as expected two weeks ago, but to actually lower them to deal with the banking crisis.

These expectations of investors diametrically contradict the statements of Jerome Powell, the head of the Fed. He said last Wednesday, when he announced the 0.25% rate hike, that this year interest rates will not fall. Such completely different assumptions are rare. Who will get it right? The Federal Reserve or the investors.

There is a stock market saying about this, "The FED is always right." The Federal Reserve is always right. They have more resources than all investors combined, who also act in an uncoordinated manner.

But the FED would be well advised to heed the signs that investors are very concerned about the banking system. It is safe to assume that the banking crisis is not over yet.
Banking crisis is not over yet
Central banks may claim that they have the banking crisis under control and that all banks are safe, but neither the banks themselves nor investors seem to believe that.

The chart shows how much money central banks are lending to commercial banks to provide sufficient liquidity in the short term. Last week, banks demanded more money than at any time in the last 10 years. More even than during the COVID crisis. The banks do not trust their customers and are preparing for further money outflows.

Since the turnaround in interest rates, the US Federal Reserve has continuously reduced the money supply in order to get inflation under control. Because of the banking crisis, they have opened the money floodgates again on a massive scale. 2/3 of the reduction in the money supply has thus evaporated again.

That worries us about the outlook for inflation control. The Fed seems to be signaling calm, but its actions, do not match its words. If everything is not a problem, why do the central banks increase the money supply so massively and completely forget about fighting inflation?

The chart shows how extreme the Fed's turnaround was. The chart shows the two-week change in the money supply. This was almost as high as it was when the financial crisis hit.

As explained in one of the last market reports, about 1/3 of all money flows into the financial market. This was then probably also the reason why the stock markets rose slightly last week.

The chart shows the amount of money that has flowed into money market funds over the past 16 years.  Last week, a new all-time high was reached.

The chart shows how much investors have reduced risk in the past two weeks. The values are almost comparable to the COVID crisis.

The chart shows a survey of the largest institutional asset managers on where they see the greatest investment risks in the coming months. They are also worried that the banking crisis will continue. Until 3 weeks ago, this problem was not on the radar of most of them.

After the financial crisis, the ECB created the Financial Stability Index. You can read more about it here. It is intended to provide information on how stable the financial market sector is. The index also has a high correlation to the S&P 500 stock index.

The index has continued to lose value in recent weeks. Again, this is a sign that the banking crisis is not over yet.

What does an inverted yield curve mean
Normally, long-term interest rates are higher than short-term interest rates. It may be possible to forecast the economic development over a short period of time, but in the long term it is almost impossible. The investor wants to be compensated for these possible long-term risks.

In special cases, however, the yield curve reverses. This is usually the case when central banks raise interest rates. Investors then worry that the rise in interest rates to combat inflation has been too strong and that a recession is now imminent. This is precisely the phase of the long-term financial market cycle we are currently in.

The chart shows the difference between 10-year and 2-year interest rates for U.S. government bonds (blue line). Normally, long-term interest rates are higher than short-term rates. Marked with a circle in black are the phases in which this was not the case. That is, the phases in which the yield curve was inverted.

In ALL such cases since 1985, a recession occurred 6-9 months after the inverse yield curve occurred. In addition, the unemployment rate (yellow line) then also rises sharply.

We have then also aligned our portfolios to such a scenario.

The chart shows a survey of the largest institutional investors on whether they expect the yield curve to reverse in the coming months. This is the case for most of them.
In the current phase of the financial market cycle, it pays to invest in solid substance stocks. But gold should not be forgotten.

The graph shows the return of gold compared to the S&P 500 stock index in the U.S. after an inverse yield curve occurred (blue line). The orange line shows the development in the recession from 1973 to 4, which is always considered by many investors as the most current similar situation.

What currently worries us the most is this graph here:

The chart shows the annual growth rates of earnings of all companies in the S&P 500 Index (blue line). The orange line shows an index of the investment bank Morgan Stanley, which is based on various leading macro data. In the past, the index has had good predictive power. Based on this index, earnings growth should now be declining sharply. However, most investors (yellow line) do not currently expect this to happen.

Another indication that it is currently appropriate to invest conservatively and to focus on substance and quality stocks.

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