The spring of bonds and the risk of stagflation

Almost two years have passed since the Fed's article “(Don't Fear) The Yield Curve, Reprise” where the 10y-20y curve was put in the attic to use the “Near Term Forward Spread” (the near term forward spread is the difference between the expected 3-month interest rate and 18-months from now minus the current 3-month yield).
What is the situation today? Considering historical precedents, the recession comes 1-2 years after the inversion of the two curves, the last time the inversion occurred in October 2022.
When inflation appeared, the inversion of the curve accelerated the descent, otherwise rates would probably have reached the “risk on” trigger level of 3.5%.
Instead, the stock markets fell from the tops of 2021 until October 2022, with a new panic in March 2023 with SVB (but without retesting the lows of October 2022), and then went into a bullish rally up to the recent tops.
It is currently advisable to remain liquid or, for those exposed, to liquidate part of the equity positions before the curve reverses towards normality (greater than zero).
But will it be a recession? According to the Fed paper it will be very likely when the NTFS is lower than 10y-2y.
On March 8, 2024 the values were -1.287 NTFS versus –0.39 10y-2y.
The Fed is afraid of recession, but it cannot lower rates, otherwise there would be a risk of stagflation! Compared to 2 years ago, the 10y – 3m spread has become negative and the probability of a recession in 2024 has increased over 50%, reaching almost 75%.
Compared to two years ago, the curve has also reversed in Europe, except in Italy and Spain.
Over the last two years, the American indices have again reached historic highs, recovering all the inflationary drawdown and the rate hike.
The main dilemma, even for an entry into bonds, is inflation: is it really under control and will rates therefore fall by the end of 2024? The CME FedWatch Tool continues to kick the can down the road and from the cut in March that was expected in late 2023 we are now moving from June to July.
Inflation seems to be defeated in theory but also not completely defeated, like the embers under the ashes of a fire that could dangerously revive the fire if it is not extinguished immediately.
Obviously the high uncertainty makes every choice difficult but, considering the evolution of the graphs, it can be summarized: 1) If the curve becomes positive again there will be a high probability of seeing a recession and identifying a buy at the trigger level of 3.5%; 2) If the curve continues to fall lower then the risk of stagflation will become more and more concrete; 3) The stock market continues to rise (or lateralize) until the summer, reversing the trend in the vicinity of the American elections.
The market is unpredictable, but possible scenarios can be constructed, hypothesizing suitable and diversified strategies in terms of assets, time and sizes, based on the type of management relating to your risk/return/time profile.
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Author: Hermes A.I.

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