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Are Flattening Curves And Style Rotations Deceptive Omens?

Zero Rss
1 month ago
Are Flattening Curves And Style Rotations Deceptive Omens?

Authored by Michael Lebowitz via RealInvestmentAdvice.com,

Bond market pundits often warn that bear yield curve flatteners or inverted yield curves ultimately lead to recessions. Similarly, some equity experts caution that periods of violent back-and-forth rotations among stock sectors and/or style factors are precursors to a market top.  Additionally, the combination of a bearish flattening trend and volatile equity rotations leads some analysts to forecast a recession, with concerning market repercussions.  

The argument we present in this article is that predicting economic or financial market activity is not as simple as following two indicators. Bear flattening trades, inverted yield curves, and frantic style (factor or sector) rotations are not definitive warnings of a market peak. They are extremely informative about where the economy, markets, and investor sentiment stand, but they do not tell investors whether or when the economic or market cycle will turn. Knowing where you are in a cycle is not the same as knowing when it ends. Confusing the two is a common mistake and can be a costly one for investors in late-cycle analysis.

Given that both indicators are currently flashing red, we explore how they can serve as important warnings of pending financial market and economic turbulence, but also as deceptive omens.

What The Yield Curve Tells Us

The shape of the yield curve, or the difference in yields between long and short-term US Treasury securities, indicates the market’s expected path for short rates plus a term premium. In other words, where does the market expect Fed Funds to be in the future, plus how much of a yield premium is the market paying investors to take on the inflation, economic, and oversupply risks of holding Treasury securities?

To help appreciate where the yield curve stands today and how it’s changed recently, we’ve included the graph below.

A notable feature of this long-term graph is that every time the yield curve flattened and inverted, i.e., the 2-year yield rose above the 10-year yield (the blue line fell below 0 on the y-axis), a recession (gray) followed. There is one exception. In 2022, the curve flattened, inverted, and then steepened, yet a recession has not materialized. 

Current Yield Curve Flattening

Recently, the yield curve has been flattening (declining) while bond yields have risen. In bond market parlance, that is called a bear market flattener (higher yields and a flattening yield curve). The table below shows that since late February, when the Iran conflict started, the 2-year note has risen by 76 basis points, the 10-year note by 46 basis points, and the 30-year bond by only 25 basis points. As a result, the 2/10-year yield curve flattened by 30 basis points and the 2/30-year curve by 51 basis points.

A bear flattening is the result of investors raising their collective expectations for higher short-term rates. This can be due to strong economic growth expectations and/or higher prices. At the same time, longer-maturity yields are less responsive, likely due to a subdued long-run growth forecast or a belief that higher inflation is temporary.

The flattening or inversion of the yield curve creates more restrictive financial conditions, acting as a brake on economic activity. An economy that warrants slowing is often one that is late in its economic cycle.

When the long-maturity yield falls below the short-maturity yield, i.e., it inverts, the usual interpretation is that investors expect future rate cuts because policy and/or rates are restrictive enough that the central bank will have to reverse course. However, that definition fails to consider the term premium, the compensation investors demand for holding longer-duration notes and bonds. A curve can flatten or even be inverted because the market expects rate cuts and/or because the term premium has compressed toward zero. Thus, it’s not definitive whether an inverted curve is due to expected rate cuts, well-anchored inflation, or forecasts of an economic downturn.

Equity Rotations

Equity leadership can be a tell of similar concerns, but through a different mechanism. Stocks are claims on future corporate cash flows, and those claims have duration. For instance, growth companies tend to have minimal cash flows or even run losses in the near term, but expectations are for large and growing earnings in the future. Thus, valuations for growth companies are based on distant-future cash flows and, accordingly, have a long duration.

Conversely, value companies generate cash flows that are nearer and more certain and are therefore considered to have shorter durations. When short-term interest rates rise and uncertainty about the future increases, the present value of distant cash flows is marked down far more than that of near cash flows.

For example, the 1-year present value of $100 at a 5% discount rate is $95.24, and at a 4% discount rate, it’s $96.15. The 1% change in rates impacts the present value by $0.91. Conversely, the 10-year present value of $100 at 5% and 4% is $61.39 and $67.56, respectively, resulting in a difference of $6.17 for the 1% change in rates. Accordingly, valuation multiples of growth companies tend to compress relative to those of value companies.

As we share below, in a hypothetical example, the value of the future cash flows of a value company with more upfront cash flows declines less with a 3% increase in the discount rate than that of a growth firm with more cash flows expected in the distant future.

A growth-to-value rotation is the equity market’s version of the yield curve flattening: both are duration-related repricings driven by the same change in the cost of money.

When Rotations Become Volatile

Typically, equity rotations in a late-cycle market become more volatile. In other words, no style or sector leads or lags for long stretches. These rapid rotations help clue us into a market regime that is becoming contested or changing.

Through the middle of an expansion, the macro picture is often clear with trend growth, accommodative or neutral monetary policy, and a steady discount rate. Because the regime is stable, leadership often remains in place for long periods as investor capital concentrates on the companies that benefit most from prevailing conditions. However, the market regime becomes challenged as changes in the broad economic and market environment are anticipated. Investors start asking questions such as:

  • Is monetary policy changing?

  • Is growth decelerating or reaccelerating?

  • Is inflation sticky or transitory?

As new economic and corporate data feed into the market, the discount rate becomes more sensitive. The market is forced to continually toy with its assumptions, and leadership ping-pongs as a result.

The volatility of style leadership is a proxy for regime uncertainty. The whipsaw action itself, not necessarily which types of stocks lead or lag, is the tell. A market that cannot decide between value and growth is a market that cannot decide what the discount rate will be, which is to say, a market that senses the regime is changing beneath it.

False Signals

There is a complication with what we have presented. The yield curve can be distorted by forces unrelated to the business cycle, such as shifts in the bond term premium, large-scale asset purchases (QE) or their reversal (QT), and significant government bond supply.  Equity rotations are at times heavily influenced by momentum chases and bouts of speculative behavior. Moreover, the rise of passive investment strategies tends to accentuate momentum trends.

When other factors influence the yield curve or the volatility of equity rotations, the “forecast” embedded in the curve and rotations becomes muddied and can falsely signal a market and economic top.

Condition And Timing Indicators

This brings us to the distinction that should govern how the signals are used. There is a difference between a condition indicator and a timing indicator. A condition indicator describes the economic and market landscape. A timing indicator tells you when the next event arrives. Flat curves and unstable leadership are good indicators of conditions, but can make for poor timing indicators.

This concept is like weather forecasting. A falling barometer tells you the atmosphere favors a change in the weather, likely a storm. It does not tell you what day or time the storm will arrive. In fact, despite the drop in barometric pressure, the storm may never form. Reading a barometer as a surefire countdown clock to a storm is an error, no matter how reliably storms and falling pressure correlate.

Summary

If you cannot extract a time frame for an economic and market peak from these signals, then what purpose do they serve?

The answer is that they help us prepare for a widening series of potential outcomes. Today, for instance, with the yield curve flattening and a series of violent rotations, we are maintaining stricter stop-loss levels, paying closer attention to technical analysis, focusing on our SimpleVisor rotation analysis tools, and assessing our risk more frequently.

The signals suggest the regime may be changing, and we should be prepared for that possibility. However, until that becomes more evident, we must take advantage of what the market has to offer. 

Tyler Durden Wed, 07/08/2026 - 14:25
Tyler Durden

FOMC Minutes Show 'A Few' Fed Members Wanted To Hike In June, 'Majority' Fear Higher Inflation

Zero Rss
1 month ago
FOMC Minutes Show 'A Few' Fed Members Wanted To Hike In June, 'Majority' Fear Higher Inflation

Tl;dr: The minutes underscored a more hawkish tone on inflation. UBS traders noted that most participants cited scenarios in which price pressures could remain elevated, including stronger AI-related demand, the ongoing Middle East conflict and tariffs. In those cases, nearly all of those officials said some additional policy tightening would likely be warranted. Fed staff raised their inflation outlook for 2026 and 2027 compared with the April forecast, reflecting the effects of the Middle East war and AI-driven investment, while trimming their GDP growth outlook slightly.

*  *  *

Today's FOMC minutes will be scrutinized for further insight into policymakers' appetite for additional rate hikes and the thinking behind the Committee's hawkish shift at last month's meeting. The minutes are an account of the June 17th meeting and therefore will not reflect subsequent developments, including the softer-than-expected June nonfarm payrolls report or Chair Warsh's appearance at the ECB's Sintra Forum.

Since the last FOMC meeting (June 17th), the dollar has strengthened (on the hawkishness) and gold (and bitcoin) mirrored that with sizable declines. Stocks are flat, bond yields are higher (prices down), and oil remains lower, but accelerating in the last couple of days...

The market's expectations for Fed actions this year have surged back near the highs (up from around 20bps pre-Warsh to around 40bps today)...

And rather interestingly, the initial dramatic flattening of the yield curve on FOMC day has been entirely erased...

As Growth-related macro data has disappointed notably while Inflation-related macro data has remained sticky/high...

So with all that said (and with all eyes watching for confirmation of the hawkish bias), what does the FOMC want us to know about Warsh's first meeting in charge...

FOMC Minutes summary:

Participants generally saw upside risks to price stability as elevated, while downside risks to maximum employment goal had moderated a bit

Inflation

  • The majority of participants commented that most measures of medium- and longer-term inflation expectations remained at levels consistent with the Committee's 2 percent objective.

  • The majority of participants highlighted the possibility that, after several years of inflation above 2 percent, continued elevated inflation rates could begin to affect inflation expectations and wage- and price-setting decisions.

  • A few participants commented that, in light of these developments, there was a case for raising the target range for the federal funds rate, but those participants indicated that they supported maintaining the current target range at this meeting.

  • Most participants remarked on scenarios in which inflationary pressures would dissipate and inflation would soon begin to return to 2 percent. In such scenarios, almost all of these participants noted that it would likely be appropriate to maintain or eventually lower the target range for the federal funds rate.

    • Most participants, however, also pointed to scenarios in which, in the context of stable labor market conditions, inflation would remain elevated due to strong AI-related demand, the conflict in the Middle East, or the effects of tariffs.

    • In such scenarios, almost all of these participants indicated that some policy firming would likely be warranted to return inflation to 2 percent.

  • Some participants observed that the sharp rise in input costs reported in business surveys raised concerns about the potential for higher energy and commodity costs to pass through more broadly to final goods prices.

  • Several participants noted, however, that firms in their Districts reported that they had been cautious about increasing prices, citing concerns that higher prices could reduce demand or their market shares

  • Several participants noted that the deceleration in housing services prices was likely to continue to be a source of disinflationary pressure.

The Fed appears to now be officially blaming AI for rise in core inflation: 

"Core goods price inflation had risen relative to a year earlier, which the staff judged as largely reflecting the effects of tariffs and AI-related price pressures"

...

Many participants noted that ongoing strong demand for AI infrastructure would likely sustain upward pressure on prices for technology products and electricity..."

...

"Some participants remarked that productivity gains associated with AI adoption would eventually reduce production costs and increase aggregate supply, which should put downward pressure on inflation, though they noted this effect would likely take time to materialize"

...

"Initial public offering activity in the U.S. appeared set to accelerate this year, with the proceeds expected to help fund ongoing investments in AI infrastructure."

Growth

  • Most participants remarked that growth in economic activity that exceeded that of potential output, owing in part to strong AI business investment, could contribute to more persistent inflationary pressures.

  • With respect to household spending, most participants observed that stock market gains and federal income tax refunds sent earlier this year had provided support to consumer spending, particularly among higher-income households.

  • Most participants remarked that growth in economic activity that exceeded that of potential output, owing in part to strong AI business investment, could contribute to more persistent inflationary pressures.

  • Some participants remarked that productivity gains associated with AI adoption would eventually reduce production costs and increase aggregate supply, which should put downward pressure on inflation, though they noted this effect would likely take time to materialize.

Communication

  • A majority of participants remarked that they saw advantages in shortening the statement.

  • Some participants commented that they welcomed the opportunity to review the Committee's communications tools and practices.

  • Most participants emphasized that they preferred not to repeat the language in the previous postmeeting statement that had suggested an easing bias regarding the likely direction of the Committee's future interest rate decisions.

Policy

  • Several participants remarked that they did not see the current policy stance as restrictive, while a few other participants commented that they saw the current policy stance as slightly restrictive.

FX

  • There were no intervention operations in foreign currencies for the System's account during the intermeeting period.

Read the full FOMC Minutes here.

Tyler Durden Wed, 07/08/2026 - 14:05
Tyler Durden

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