At the Junction of Peak Inflation, Recession, Treasury Yields Top, and Bear Market Bottom

The market technicals, economic data, and historical comparisons are making a strong case that peak inflation, recession, treasury yields top, and equity bottom are around the corner.

The New York Times says the word of the year is ‘uncertainty.’ In a conference call with investors, the Google executives said the word or its variations 13 times. The economic uncertainty is affecting business CEOs’ plans. The financial advisors are exploring approaches to educate clients in times of market uncertainty. The sovereign wealth funds are warning of ‘profound uncertainties’ as inflation rises.

It seems like we are facing an uncertainty monster.

The future is unknown and unknowable; everything is inherently uncertain, and always has been. The only thing that changes from moment-to-moment is how your psyche processes this.

However, uncertainty is a fact of life, and no doubt, over the past few months, the economy and the stock markets have witnessed some significant upheavals raising some interesting questions.

  • Has the inflation peaked?
  • Are we in a recession?
  • Will the Treasury bond yields rise due to inflationary pressures, or will they fall due to slowing economic growth?
  • Has the stock market bottomed?

These questions put the global markets at a crossroads as their answers will strongly influence investment decisions.

Has the Inflation Peaked?

Fig. 1: Inflation & Inflation Expectations

In 2022, inflation reached levels not seen since the early 1980s in most major economies. It reached 9.1% in the U.S., 9.4% in the U.K., 8.6% in the Euro Area, 8.2% in Germany, 6.5% in France, and 8.5% in Italy. It is also high in Latin America, Asia, and Oceania. This is raising cause for concern around the globe that the central banks and policymakers are struggling to address.

However, there is a lot of chatter in the media about peak inflation (see here, here, here, and here). So is the inflation peaking?

The breakeven inflation rates make the case that inflation has peaked for this cycle (see Fig .1 ), and so are some market analysts. But some other economic indicators and experts say that we haven’t seen peak inflation yet.

Fig. 2: C.R.B. Commodities Index and S&P GSCI Commodity Index

In May 2022, the Core PCE, the Fed’s preferred inflation gauge, was 5.5%, following three monthly declines from the peak reading of 6.1% in February 2022. It inched up in June to 5.6%. All other indicators in Fig. 1 are below their peaks.

The commodities prices are also declining after making new highs a few months earlier (see Fig 2.). The C.R.B. Reuters/Jefferies Commodity Index and S&P GSCI Index made highs in early June 2022; since then, they have been declining. In early July, they both fell below their previous lows, indicating that their bull market has either ended or has a high probability of finishing. Falling commodities prices are usually deflationary.

There is no doubt that the falling commodity prices, bond yields, and inflation expectations are making a case for peak inflation. And as they say, “the cure for high prices is high prices.” So, even if we are not at peak inflation now, there is a high probability that we will see it before the year-end. There are caveats, though.

Identifying peak inflation is important because the bottom of the stocks and the top of Treasury yields usually occur before the peak inflation. Historically, Treasury Yields tops and S&P 500 bottoms occur 2-3 months prior to the inflation peaks. The flip side is that the stock market bottoms and the Treasury Yields tops indicate that peak inflation is around the corner.

Are We In a Recession?

Economists and market participants generally agree that the U.S. economy is slowing down but not whether it is in a recession. The agreement on slowing down is due to the factual nature of the economic data. The disagreement is due to different definitions of recession used.

The official arbiter of the U.S. recession, the National Bureau of Economic Research (NBER), defines a recession as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” NBER’s Business Cycle Dating Committee dates the start of a recession many months after its actual start. This is because economic data undergo many revisions following their initial release before stabilizing. The NBER has not yet announced a recession and may not do so for many months.

A more common or folksy definition of a recession is “two-quarters of negative G.D.P. growth.” U.S. economist Julius Shiskind is credited with this definition of a recession. Some, like the Reserve Bank of India (R.B.I.), call it a technical recession. The R.B.I. used that term when India recorded two-quarters of negative growth for the first time in the first half of 2020-21 following the Covid-19-induced shutdown of the economy.

The first reading of the G.D.P. for the second quarter of 2022, the Advanced G.D.P., came out to be -0.9%, following the negative reading of the first quarter. So using this definition, technically, the U.S. is in recession.

Fig. 3: 10-Year and 2-Year U.S. Treasury Yields Spread

Then there is the third definition of a recession, which academic macroeconomists use. They think about the economy as a slow-moving “growth trend” and short-term, fas moving “fluctuations” around that trend. A recession is when the real economy falls below the growth trend.

Using the academic definition, economic blogger Noah Smith says that we are almost certainly in a recession now as the growth has probably dipped below the trend.

An indicator we use to determine the probability of a recession is the spread between 10-year and 2-year U.S. Treasury Notes. This spread usually turns negative, as we noted in January 2017, a few months before the onset of any recession in the U.S.A. This spread first turned negative in early April (see Fig. 3), indicating a high likelihood of the U.S. falling into recession by the summer of 2023. For the past few days, the spread has been below zero.

The identification of recession helps in business cycle investing (see Fig. 4). Whether the economy is in a recession or not could be determined by evaluating economic data or through the analysis of the three asset classes ( Bonds, Stocks, and Commodities).

In the final leg of the expansion, i.e., before the economy enters the contractionary stage, all three asset classes decline. In contraction, bonds turn up first, followed by stocks and commodities.

In the current post-pandemic environment, the bonds started to decline in July 2021, indicating Stage 4 of the Business Cycle. The stocks began their decline in January 2022, heralding Stage 5. The commodities commenced their fall in March-June 2022, marking Stage 6.

Bonds bottomed in June 2022 and are moving up since then. Stocks usually follow bonds with a lag.

Will Treasury Yields Rise or Fall?

Fig. 3: U.S. Treasury Yields

So far, the Federal Reserve has raised the fed funds rate four times in 2022 by a combined 2.25%, meaningfully impacting inflation and the Treasury Yields.

The U.S. Treasury Yields seem to have peaked in mid-June 2022. The 10-year yields ($TNX) made a high of 3.49%, the 30-year yields ($TYX) a high of 3.47%, and the 2-year yield made a high of 3.45%. Since then, they have been declining (see Fig. 3).

The chart of 10-yields shows that it broke below the low levels reached in late April and late May and that a bearish Head-&-Shoulder pattern is emerging with a target below 2.00%. The 30-year yields are also developing a similar pattern, though it has not fallen below the lows of May or April. The same is true for 2-year yields.

Economist Katty Jones notes that the Fed funds and the 10-year yields have converged at their peak in the past. She also says that the market has already discounted more tightening by the Fed, leading to yield curve inversion and increasing the likelihood that the yields have peaked for this cycle.

Fig. 4: U.S. Treasury Yields – Weekly

The probability of the US Treasury Yields declining over the next few months is greater than that of rising. The yields are finding resistance at levels from which they turned down in the past (see Fig. 4).

The US 10-Year Treasury yields reached a high of 3.24% in the fall of 2019 before declining. In December 2013, they turned down from the 3.00% level. In November 2018, the 30-year yields turned down from a high of 3.48%. They turned down from a much higher level (3.94%) in December 2013. The 2-year turned down in the fall of 2019 from a high of 2.98%. They were under 1.5% in December 2013.

The economic environment, however, was different in 2019 and 2013. The Core PCE was 1.7% in December 2013 and was declining after reaching a high of 2.0% in January 2013. In the fall of 2019, the Core PCE was around 1.8% after making a high of 2.29% in July 2018.

In 2013, the market was highly risk-averse due to the US debt-ceiling crisis, which increased the attractiveness of the US Treasury bonds. The high levels of the US Treasury yields in 2019 occurred following nine Fed funds rate increases from December 2015 to December 2019, which preceded three rate cuts in 2019.

Has the Stock Market Bottomed?

Fig. 5: S&P 500 (Daily)

Over the past few months, the major US indices have effectively moved sideways despite some volatile up-down moves.

The S&P 500 closed at 3991.24 on May 9 and 4023.61 on July 27 (it closed at 4130.20 on July 29). In between, it reached a high of 4177.51 on June 2 and a low of 3639.77 on June 16 (see Fig. 5).

The charts of other major indices – Dow Jones Industrial Average, NASDAQ Composite, and Russell 2000 – are also comparable. So, is the stock market bottoming?

The Bear Market

The US equity market topped out in late 2021 and early 2022 when the major indices made all-time highs.

Index Date All-Time High
Dow Jones Industrial Average Jan-04-2022 36934.84
S&P 500 Jan-04-2022 4818.62
NASDAQ Composite Nov-22-2021 16212.22
Russell 2000 Nov-08-2021 2458.85
Dow Jones Transportation Average Nov-02-2021 18246.51
NYSE Composite Jan-13-2022 17442.54
Wilshire 5000 Total Market Index Nov-05-2021 49089.38

After making their respective all-time highs, the indices started to decline. In the aftermath of Russia’s invasion of Ukraine on January 24, 2022, the major indices made their respective bottom, beginning a series of lower lows and lower highs.

On February 23, the S&P 500 made a low of 4221.51, below the January 24 low of 4222.62. On March 29, it made a high of 4637.30, which was not a higher high. On May 2, the S&P 500 broke below the low of February 24, breaking the sequence of high-highs and higher lows and confirming the bear market. By this time, other major indices had also made lower lows and lower highs.

The Dow Theory Bear Market Signal

The Dow Theory, using two Dow indices – Industrials and Transportations – also confirmed the bear market by May 2022. In The Dow Theory Today, Richard Russell writes:

Bear signals may be recognized in the third pgase of a bull market, as follows (see Barron’s, Dec. 1, 1958): after a secondary reaction has been completed, an advance will take place. If one or both Averages refuse to better their previous highs, and the two then turn down, at the point where they both violate the lows of the secondary reaction, a bear market will have been signaled.

Fig. 6: Dow Jones Industrial and Transportations Averages

The third phase of a bull market is when speculation is rampant and inflation is apparent[1]Robert Rhea, The Dow Theory, Pg.44.

In our present time, this would be the rally from the December 1, 2021 lows to January 5, 2022 highs. Dow Jones Industrial Average made a new high in January, but the Dow Jones Transports Average did not. They both witnessed secondary reactions until January 24, which breached their respective lows of previous December and November. Their subsequent rallies did not improve their respective previous highs. They both breached the secondary reaction lows in late February, signaling the bear market, dating to start on January 5, 2021, when the Industrials made their new high (see Fig. 6).

Is It Time to Look For Market Upturn?

In bear markets, the rallies are secondary reactions, and declines are the continuation of the primary move. At a bear market’s beginning, it is also necessary to reclassify the market moves[2]Richard Russell, The Dow Theory Today, Pg. 36.

The reclassification will make the last secondary reaction – the decline from January 5 to January 24 – the first leg of the bear market, and all subsequent rallies will become its secondary reactions. In a bear market, the default expectation is that the market lows will the breached to the downside. However, Russell mentions a vital principle: each successive penetration of the lows in a bear market ( or highs in a bull market) carries increasingly less validity[3]Richard Russell, The Dow Theory Today, Pg. 37.

The Dow Theory postulates that, like in a bull market, there are three principle phases in a bear market[4]Robert Rhea, The Dow Theory, Pg.47. The first represents the abandonment of hopes upon which the stocks were purchased, the second reflects selling due to decreased business and earnings, and the third is caused by distressed selling.

In the last bull market, the dominant theme was ‘buy the dips.’ This theme failed in early February 2022 when buying the January dip did not result in rising prices. The second leg of the bear market decline bottomed in late February, but the subsequent rally failed in March/April, discouraging bulls. The next move down from early June to mid-June was sharp and was plagued by increased concerns about higher inflation and higher interest rate.

So far, we have witnessed multiple down legs of the current bear market with varying degrees of abandonment of hope and distress selling, though they may not be comparable to past bear market down legs. As noted earlier, we have also observed sideways moves in indices lasting many days, indicating consolidation.

There are two other significant developments. On June 17, the Dow Jones Industrial Average and the Dow Jones Transportation Average made lows of 29653.29 and 12777.25, respectively. Their subsequent bounce stopped on June 28, but their next move down did not meaningfully break their respective June 17 lows.

On July 14, the Transports bounced off from a low of 12748.12 and then broke above the high of June 28 on July 19, effectively completing a Double Bottom pattern. The Industrials did not test the June 17 lows. This divergence – new in Transports but not in Industrials – did not confirm the continuation of the downtrend. Instead, both indices bounced up from July 14 lows and broke above the June 28 highs on July 19, starting a new sequence of higher highs and higher lows.

The second significant development is that the equities have stopped declining following bad economic news. The bad CPI report on July 13 caused only one day of selling, and the stock market was higher a day later despite a bad PPI report. Stocks also rose following a 75 bps Fed funds increase, higher than expected Core PCE report, and a spate of economic data that were worse than expected.

A new bull market may not have started following the June 2022 lows, but the probability is high that the current bear market has made a bottom and is ripe for a rally.

However, the current rally needs to be contextualized with the seasonality and the existing economic conditions. Seasonally, August is the worst month for Dow Jones Industrial Average, S&P 500, and Russell 2000. Rising interest rates and economic slow-down would negatively impact the performances of the businesses, increasing market volatility. Because of the seasonal and anticipated economic weakness, the current rally has a greater than 50% chance of being a bear market rally than the start of a new bull market.

The technical analysis is afflicted by the prejudice that it does not ask the question “why?”[5]Richard Russell, The Dow Theory Today, Pg. 42


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1 Robert Rhea, The Dow Theory, Pg.44
2 Richard Russell, The Dow Theory Today, Pg. 36
3 Richard Russell, The Dow Theory Today, Pg. 37
4 Robert Rhea, The Dow Theory, Pg.47
5 Richard Russell, The Dow Theory Today, Pg. 42