Why Nifty bulls must buckle up for the next big fall

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

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

Whenever there are instances of rise in inflation, the Federal Reserve hikes interest rates to combat it. This increase in rates primarily affects short-term rates which is reflected in the higher 3 month bond yields. Such a prolonged continuation of rate hike sometimes pushes the long term US 10-year government bonds yields lower.

The long term yields are market dependent and Fed has limited control over it. 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 required to control the rising inflation.

The probability of the economy to hit a recession increases when the yield curve remains inverted for a longer period of time. Historically, as shown in the chart below, every instance where the curve dipped below the zero/black line and then rose above it has been followed by a recession.

Additionally, it typically takes a few months after the curve begins to un-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 counter this slowdown and stimulate the economy, central banks cut interest rates, reducing short-term bond yields. Meanwhile, long-term bond yields—shaped by growth, inflation expectations, and future rate projections—may stabilize or rise. This shift leads to the un-inversion of the yield curve.

This shift in interest rates can lead to the “un-inversion” of the yield curve after a period of inversion. At this point, the likelihood of a recession increases once the curve crosses the black line, often impacting the S&P 500 in a similar pattern.

Here’s the dataset of what happens to markets after yield curve un-inverts right from 1970:

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

The charts below illustrate market corrections following yield curve un-inversions.

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

As the saying goes, “When America sneezes, the world catches a cold.” The effects of these shifts are also felt in Indian markets. 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, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)