Why Nifty Bulls Should Head for the Next Big Drop

Recently the US Federal Reserve has cut interest rates by 25 basis points to 4.75% from 4.5%. The move served as the main trigger for the S&P 500’s market decline of 2.85%. Such a sharp decline in the index sent chills down the spine of investors. Most people are wondering if there is more pain in the offing.

Unfortunately, the answer is yes. Let’s see why I say this.

Whenever there are instances of rising inflation, the Federal Reserve raises interest rates to counter it. This rise in rates primarily affects short-term rates which is reflected in higher 3-month bond yields. Continuing to raise rates this long sometimes lowers the yield on long-term US 10-year government bonds.

Long-term yields are market-driven and the Fed has limited control over them. This phenomenon of higher short-term and lower long-term yields leads to yield curve inversion. This is basically the market’s way of saying that a slowdown in the economy is necessary to control rising inflation.

When the yield curve remains inverted for a long period of time, the economy is more likely to experience recessionary effects. Historically, as shown in the chart below, every event where the curve dipped below the zero/black line and then rose above it has been a recession.

Furthermore, it usually takes a few months after the curve starts to invert and crosses the black line for a recession to occur.

So, when does this un-inversion occur?

As mentioned earlier, the Fed raises short-term borrowing costs to combat inflation, which slows economic growth. To combat this recession and stimulate the economy, central banks cut interest rates, lowering short-term bond yields. Meanwhile, long-term bond yields—as determined by growth, inflation expectations and future rate projections—may remain flat or rise. This shift leads to non-inversion of the yield curve.

This change in interest rates can lead to an “un-inversion” of the yield curve after a period of inversion. At this point, the probability of a bearish increase increases when the curve crosses the black line, which often affects the S&P 500 in a similar pattern.

Here’s a dataset of what happens in markets after the yield curve un-inverted since 1970:

Since the 1970s, there have been 7 instances where markets have experienced a correction during a 6-month period. The average gain of the S&P500 is -4.8%. Notably, in the last 4 cases, 75% of the time, markets continued to decline for 1 year, and in 50% of those cases, the decline accelerated (2001 and 2007).

The charts below show market corrections following yield curve inversions.

History often follows a familiar cycle: interest rates are initially raised, triggering a yield curve inversion. In response to slower economic growth, rates are then lowered, leading to the onset of yield curve inversion. This is likely to set the stage for a potential slowdown and market correction.

As the saying goes, “When America sneezes, the world catches a cold.” The impact of these changes is being seen in the Indian markets as well. In light of this, investors should approach new investments with caution and consider rebalancing their portfolios. By staying informed and proactive, investors can navigate these changes and position themselves for long-term success.

(Disclaimer: Recommendations, suggestions, opinions and views given by experts are their own. These do not represent the views of Economic Times)