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Is the Yield Curve Inversion a False Alarm?

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Global stock markets slumped this week after the US yield curve inverted, an indicator of a future recession. This was the first time the curve has inverted since 2007, which was followed by the global financial crisis. In the past, every recession was preceded by the inversion of the Treasury yield curve. However, this time around, the inversion of the yield curve may not necessarily lead to a recession.

For starters, not every yield curve inversion in the past has led to a recession—it has been the other way around. All US recessions so far have been preceded by a yield curve inversion, and there has always been a lag between the two.

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10-year yields have been driven down to unnaturally low levels

Secondly, 10-year Treasury (IEF) yields have been driven down to unchartered territory this decade. The extraordinary bond-buying program by the Fed to increase the liquidity in the system after the financial crisis caused yields to plunge.

The federal funds rate after the financial crisis stayed at 0% for years, which was unprecedented as well. Additionally, the US economy has been performing much better than in Europe and Japan. The central banks in those economies followed the Fed’s lead. However, their ultra-loose monetary policies did not stimulate their respective economies.

This chain of events caused these government yields to fall below 0%. As a result, US Treasury yields, while low, looked attractive to investors in Europe and Japan, especially to those looking for credit-risk-free bonds. These factors have caused the US 10-year Treasury to remain unnaturally low, even though government debt is mounting.

Meanwhile, as the Fed hiked the funds rate, the lower end of the maturity spectrum has seen its yield increase over the last few years. These have been the main factors that caused the inversion. The spread between the 10-year and two-year Treasury bonds has been gradually narrowing over the past decade.

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Risks to the US economy

Yes, the US economy faces a lot of risks. The US-China trade war has the potential to slow down the economy considerably, possibly leading to a recession. And yes, we are at the late stage of the economic cycle, which has lasted over ten years.

Certain indicators like the manufacturing PMI suggests that the economy is slowing. The US GDP grew 2.1% in the second quarter, compared to 3.1% in the first quarter. However, some economic data reveals that the economy such as US retail data for July, which is still on solid footing.

The Commerce Department said that US retail sales climbed 0.7% unannualized in July, month-over-month, which is a significant improvement from the 0.3% gain in June.

The economy remains on a strong footing for now

Growth in online retail was particularly strong, according to the retail report. e-Commerce giant Amazon (AMZN) had another record Prime Day in July. The strong retail report caused Amazon’s stock, which has lost more than 11% in the past month, to rise 0.75%.

The news caused the S&P 500 Index (SPY) to rise 0.25% on Thursday. Despite all the negativity, the index is still up nearly 15% this year. Also, the S&P 500’s earnings in Q2 was better than most expected.

Strong growth in the retail sector suggests that US consumers are still ready to spend, and consumer sentiment is good. Consumption makes up nearly two-thirds of the US economy. Meanwhile, the Services PMI readings have also been positive, rising in the last two months.

Divisive politics in the US and around the world are concerns, and the US and China seem far away from a trade deal. That said, the economy is in better shape than many perceive. Here are some ways you can hedge your exposure to the US-China trade war.

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