Eurodollar Curve Says Peak in Rates Around End of 2019?
When the market speaks it makes sense to listen. Our chart this week looks at the changes in the Eurodollar yield curve over the past year. Eurodollar futures are the backbone of the global banking system. They reflect the expectations for (LIBOR) funding rates for the next decade. For example, the 2-year interest rate is made up of a series of 8 quarters of 3-month rates. Welcome to the swap market, the largest derivatives market in the world, and the lifeblood of the banking world. Banks generally borrow short and lend long for their funding books. When the yield curve inverts, banks struggle to make money lending and credit contracts. In modern times, it’s the core of the economic engine, the credit cycle is the biggest driver of economic growth and contraction.
In the past few months we have started to see the curve invert around December 2019 at a rate of about 3.20% meaning about 2 or 3 rate hikes over the next year. And while the back months still point to higher rates, they are at 3.5% all the way out to 2028. Historically, an inversion in the swap market curve like this is a good proxy for when the recession could hit. We need to watch the behaviour of floating rates around this key inflection point for a sign that they will be pricing in the next easing cycle. We are not anywhere close to that yet.
It looks like 2020 is where consensus is building for the next recession and based on recent earnings reports, we should expect to see some pressure build on forward earnings estimates. Current estimates for the S&P 500 area bit below 180 for the end of 2019 and a ridiculous 197 for the end of 2020.
If 2020 is a recession year, and it’s a bit worse than average (it could be far worse than average), earnings for 2020 will fall about 25%. So the 180 for 2019 turns into about 130-135 for 2020. The range of forward price to earnings ratio in a recession is between 11-14 with an average around 13 which gives us a downside target for the S&P 500 around 130 eps x 13x = 1690, but it could be as low as 1430. The previous highs in the 1500s from 2000 and 2007 could offer some support.
Interest rate markets and the yield curve are our best forecasting tools for timing of a recession, but none of this is an absolute. Historically, the S&P 500 falls about 30% in a recession and could easily be 50%. Some mitigating factors will be policy response as it often is. A Democratic House of Representatives could see a massive spending bill for infrastructure in 2020 pushing a technical recession out further, but not eliminate it.
I expect equity markets will stabilize this week and have a bounce back rally into yearend. If we can’t make a new high in the S&P 500 by the end of Q1, it will be a confirmation that the recession is lurking and we should get ready for a bad 10-18 months of equity markets. For now, we are cautious tactical dip buyers.
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