Dare We Say, ‘This Time is Different’
As we reach the midpoint of 2023, opinions abound regarding where the year will ultimately conclude. The equity markets hit their low point during the current hiking cycle in October 2022. Since then, we have witnessed a rally of over 22% in the S&P 500, with Apple (AAPL) recently achieving a record-breaking $3 trillion market valuation. While some analysts dismiss this as another bear market rally, the duration of this rally has already surpassed those seen in the bear markets of 2000-2002 and 2007-2009. Even the Great Financial Crisis of 2008, which experienced an 18.5% rally over 7 trading days and a 24.2% rally over 34 trading days, falls short in comparison. The current rally has exceeded 22% and has extended over 180 trading days, suggesting that time is not favoring the bears.
Despite time not being on the side of the bears, the holy grail of the inverted yield-curve has remained a north star for hold-outs reluctant to switch their analysis. The 2-year-10-year inversion, which has been the most consistent indicator since the 1970s, remains near a 40-year low at -1.02 as of June 29. The last time we witnessed such a steep inversion was in 1981 when we experienced a "double-dip" recession of considerable magnitude. The strength of the yield curve as an indicator of recession stems from two factors: the reason for its inversion and the economic impact of the inversion itself. Inversions occur when the Fed raises short-term rates while investors seek longer-term investments to navigate anticipated turbulent times. This shift in demand lowers the short-end and increases demand on the long-end, resulting in the inversion.
When short-term rates yield more than long-term rates, it creates challenges for a debt-financed financial system that relies on the money multiplier effect to drive economic growth. This poses obstacles to sustaining increased valuations of companies that support the economy. As the yield curve inverts further and remains inverted for longer periods, it becomes increasingly difficult for the economy to find avenues for sustained growth. This is coupled with equity prices reaching the top of their rally, long-term bonds yielding less than short-term bonds, and the possibility of the Fed pausing or slowing down its hiking cycle for the short-term. As a result, investors begin to seek alternative opportunities for risk-adjusted returns. Short-term investments start appearing more attractive than equities at current prices or long-dated bonds. Consequently, the demand shifts, and funds flow out of equities and long-dated bonds, gravitating towards low-volatility, attractive returns in short-dated treasuries.
If the yield curve has such a significant impact on the economy, why has this rally lasted longer than any other recent rally? The answer lies in the uniqueness of the current situation, as indicated in the title of this article: "This Time is Different." In March of this year, the effects of an inverted yield curve took hold in the real economy. Banks found themselves in a precarious position, with treasuries on their balance sheets being worth only a fraction of their face value compared to the deposits they held as liabilities. Our economy teetered on the edge of a credit crisis with the potential for far-reaching repercussions throughout the system. However, the Federal Reserve intervened with yet another new acronym, known as the Bank Term Funding Program (BTFP), coupled with loans provided to insolvent banks through the FDIC. Banks were able to use their assets, valued at a fraction of their face value, as collateral to the Fed and receive the face value in return. It is worth noting that this special treatment is not available to regular investors who suffer bond losses, but banks enjoy special privileges from the Central Bank.
The liquidity loans provided by the Fed to avert the credit crisis peaked at over $300 billion in mid-May and are visible in two separate line items on the Fed's balance sheet, released every Thursday afternoon. Although this amount has since decreased by roughly $20 billion, banks continue to access the BTFP. The injection of liquidity during a time when it was most needed proved effective in the wake of the bank failures we experienced in March. Since then, we have seen headlines regarding the coupling of artificial intelligence (A.I.) with $300 billion in liquidity loans to the financial system. In hindsight, it should not come as a surprise that the bear market rally has endured for this extended period.
It is essential to distinguish that the $300 billion in liquidity loans are not quantitative easing (QE). They are loans with a cost of approximately 5% for banks. This liquidity injection served as a lifeline for our economy at a critical time. However, unless there are additional policy shifts or the introduction of new acronyms by the Fed, the liquidity injected will eventually be withdrawn from the system, leading to a reduction in liquidity greater than what was initially injected. As we enter the second half of 2023 with popular index equity prices more than 22% higher than their recent lows, and if the upward trend continues, short-term treasuries yielding more than 5% without volatility become increasingly appealing to investors in search of yield. The demand shifts once again, and perhaps, this time may not be as different as we initially believed. As an investor, I would seek a place that is participating in the current growth while protecting capital and is ready to tax-efficiently be opportunistic once that fulcrum has shifted.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.