Let’s Talk Yield Curve, Historical Fractals, and More

On my data (TradingView), it looked like the yield curve almost inverted but did not, but I’ve now seen some screenshots from some Bloomberg terminals showing that it in fact did today. And the data on those will be better. And that introduces a whole new set of ideas for us.

As most of you will know, when the 10-year and 2-year treasury yields invert, it is among the very best forecasters of recessions. Also, as many of you know, an inversion tends to lead market tops, averaging about six months (a few times it’s been shorter, often much longer).

It is also true that everybody knows this.

So, a lot of people will accept this as an equity bullish signal, at least for the time being.

But there are a few things that concern me here.

  1. We had an inversion in August of 2019, and though we did have a pandemic lockdown-induced recession, we didn’t really have a recession, nor did we really have a bear market, either. As it turned out, the COVID crash was a mere correction, in the big scheme of things. While it was greater than a 20% decline, it was hardly long enough to give us that feeling of a bear market.
  2. Inversions often happen in groups: for instance, we inverted briefly in June of 1998, then the curve rallied, then it inverted again in January of 2000, and then the market topped in March of 2000, after which we had both a recession and a bear market.
  3. Notice that the ’98 inversion led the actual dot-com bust by over two years. As it turns out, the 2019 inversion may have led a looming recession by about the same amount of time.
  4. In other words, what I think no one will anticipate here, is that we may be much closer to a serious bearish decline, not realizing that the 2019 & 2022 inversions belong in the same family. I’m not saying this will happen: I’m suggesting that I am wide open to it here, and I will lay out a few reasons:
    • We do not know the extent to which the collapse of Russia’s economy will have on the world, but it may be more than we at first think; and their collapse is almost certain, in my opinion.
    • It seems to me that the Fed really may have to raise rates hard to fight inflation, and that may also send us into a deeper recession.
    • Everyone is looking at yield curve inversions from the last 20 years, but not many people are old enough to think to look back 40 years, and we’re all programmed through recency bias to expect the market to behave as it has in the last two decades, but an actual inflationary environment is something few of us have traded as adults, and we need to look back further.
    • As a result, expecting the Fed to ease before they’ve even begun to really tighten may be entirely wishful thinking.
    • They may have to raise rates a lot and for a long time, if they’re serious about inflation. I see very little that is equity bullish about that.

Furthermore, I am increasingly convinced that this rally is short covering and once it’s done, I am expecting it to fade. There seems to me to be way too many people suddenly calling for the melt up now just mere weeks after everyone was calling for a bear market (this is the result of an emotional market, driven in large part by retail traders, and that should mean that we are very near if not past a major top.

And the structure I think the S&P 500 is forming, is something I have seen before. And I don’t really like it. I hinted at it as a possibility here, and I have a better variation of it now after some more consideration.

ES

Unless we keep going up, this is effectively a huge bear wedge. If we were genuinely impulsing up, we should have had a good wave 2 in here, and we don’t. Internally this whole thing counts better as a correction, not as a good, major bottom, followed by a real institutional shopping spree. Now, I want to focus on the shape of that structure.

This is of course from early 2000:

ES

And you can sort of feel the “back to normal” psychology working on everyone right here as we rally. So, we need to be careful that we’re not replicating that fractal here today. If the 2019/2022 yield curve inversions are really pointing to the recession that all the fiscal and monetary stimulus prevented, and if there’s no political will to repeat those, we must remember that consumer sentiment is at multi-decade lows right now, and whether we like it or not, we’re a consumer economy above all else. So, we definitely are at risk of seeing a recession and full-on bear market.

I wasn’t as open to this on the way down, but the depth of the selloff was instructive to me, and doing my best to gauge people’s sentiment along the way has given more weight to this than I would have without it. It seems to me that folks—while somewhat bearish during the decline—weren’t all that bearish, and to me that makes me think that damned near everyone wants that melt up too much.

And I just don’t think Apple can get to a 6 trillion dollar market cap.

Now, there are a couple of things that will make me change my mind.


One, $BTC. Right now, it seems to me to be effectively in its own big bear flag (green parallel rails). I don’t like it, just like I don’t like the structure that I think is forming on the US indices.

We’re above the head and shoulders neckline (orange trend line) but unless we go up a lot more, we still risk a huge breakdown. And note the two last daily candles: that is called a “tweezer top,” and it’s not great to see right here after a rally. So, this breach of the neckline while within a bear flag offers ingredients for a bull trap.

Now, if this invalidates its bear flag, I will reconsider. But not until then. Indices are almost back at their highs, this is nowhere near its and everyone is calling for $100K again already. I don’t like it.

BTC


Two, $VVIX. This has been supported by a upward-sloping trend line for several years. Interpretation: institutions (who are the vast majority of the participants who hedge using the $VIX have—on average—thought it necessary to increase their hedging as time has gone on. That means they have been seeing increased risk over this period. Maybe they understand the structural problems with our economy.

But, if this breaks trend, it may be an incredibly bullish signal. It may mean that we’re actually entering a new period where institutions feel they need to hedge less in the $VIX than they have these last few years. That would be amazing. I would generally interpret that as them knowing that the economy is genuinely going to do very well for a very long time ahead of us.

Presently that is very hard to square with the yield curve inversion. And that’s why I’m watching this closely. A few days below the trend line won’t mean anything to me. But if it gets below it and stays below it, and if there’s any good economic news, or more stimulus, or any number of things that can invalidate what the yield curve inversion suggests to us, then we will need to pay attention to that.

VVIX


So, for the time being, I will be somewhat bearish until the US indices build a better structure that I like, Bitcoin builds a better structure that I like, and things like $VVIX show me that institutions are optimistic about the future.


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