Yield Curve Inverts: Stock Markets on Borrowed Time?


Aug. 14 2019, Published 10:44 a.m. ET

The stock markets can’t seem to catch a break. At first, investors were anxious about escalating trade war tensions. As a result, there were many down days on Wall Street. Now, a new concern has cropped up for markets. The most-watched part of the yield curve inverted on Wednesday.

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Yield curve inverts

When the yield curve inverted, it sent recession warnings across markets. Before we discuss the bond markets and their implications for markets, we’ll see how easing trade tensions impacted the markets.

Trump backtracked on China tariffs

On Tuesday, President Trump backtracked on Chinese tariffs. The United States Trade Representative announced that some items, including smartphones, laptops, and clothing, will be removed from the tariff list. The tariffs on other items have been delayed from September 1 to December 15.

As reported by CNBC, President Trump told reporters, “We’re doing this for the Christmas season.” He also said, “Just in case some of the tariffs would have an impact on U.S. customers.” However, many analysts think that President Trump delayed the tariffs due to his obsession with stock markets. Read Did Markets or Consumers Prompt Trump’s Tariff Delay? to learn more.

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Stock markets rejoice as China tariffs get delayed

On Tuesday, the stock markets were temporarily on a high as trade tensions eased. The S&P 500 (SPY), the Dow Jones Industrial Average (DIA), and the Nasdaq Composite (QQQ) rose 1.5%, 1.45%, and 2.2%, respectively.

Apple (AAPL) shares led the markets higher and rose 4.2%. The recent trade war escalation had a significant impact on Apple. The news also benefited Nike and Under Armour.

Bond markets flash a recession signal 

However, the market’s exuberance seems to be short-lived. Since trade tensions subsided, the bond markets are flashing a recession signal. For the first time since 2007, the US 10-year Treasury bond yield (IEF) broke below the US Treasury 2-year yield (TLT). The yield on the 30-year bond (TBT) also fell to the lowest level.

After the two-year to the ten-year segment of the yield curve turned negative, the stock market futures fell. At the opening today, the S&P 500, the Dow, and the Nasdaq opened 1.5%, 1.5%, and 1.7% lower, respectively. Bank stocks were impacted the most. The stocks have a hard time making money in a falling interest rate environment. Bank of America, Citigroup, and J.P. Morgan fell 3.2%, 3.7%, and 3.0%, respectively, at the opening. 

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Yield curve and economic slowdown

Part of the yield curve has been inverted for a long time including the three-month to ten-year segment. However, an inversion of the two-year to ten-year part of the yield curve is a very strong signal of an upcoming recession. The inverted yield curve doesn’t cause a recession. The curve highlights the vulnerability. However, the inversion implies that investors are concerned that future short-term rates will be lower than the current rates, which could imply an economic slowdown.

Gundlach warned about rising recession risks 

During an interview with Yahoo Finance on August 6, Jeffrey Gundlach, the so-called “bond king,” warned that the probability of a US recession happening before the 2020 US presidential election rose to 75%. He looked at the yield curve to make the prediction. Gundlach mentioned that one market indicator that is “full-on recessionary” right now is the yield curve. He thinks that the yield curve looks “a lot like 2007.”

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Economic indicators signal weakness

The weakening economic environment is also verified by other economic indicators. The global PMIs have been weakening. However, deteriorating sentiment surveys and worse future consumer expectations also point to upcoming problems. On Wednesday, China released its industrial production, retail sales, and fixed-asset investment data. All of the data points were worse than expected, which compounded China’s slowdown fears.

Investors seek safe havens 

Investors usually fly to safe-haven assets like bonds during uncertain times, which drives their yields lower. Read Bond Yields Sink, Gold ETFs Soar on Rising Recession Fears to learn more. Gold also benefits during uncertain times. The SPDR Gold Shares (GLD), which tracks the movement of physical gold prices, has risen 17% year-to-date. GLD has risen 17.3% since the end of May when trade tensions started escalating. In Why Jeffrey Gundlach Sees Huge Upside in Gold, we discussed that Gundlach sees gold rising to $1,600–$1,700 per ounce due to rising negative-yielding debt.

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How much time do stock markets have?

Historically, the inversion of the two-year to ten-year curve predicted every recession in the past 50 years. There have been some false alarms as well. The time gap between inversion and the actual recession has varied from one to two years. Last time, the yield curve inverted in December 2015 and the recession hit after almost 22 months.

Citing data from Credit Suisse, CNBC reported that stock markets usually have another 18 months after the inversion of the two-year to ten-year curve before trouble starts.

On Monday, Bank of America Merrill Lynch said, “The S&P 500 [is] on borrowed time if the 2s10s yield curve inverts.” According to Bank of America Merrill Lynch’s technical strategist, Stephen Suttmeier, “Sometimes the S&P 500 peaks within two to three months of a 2s10s inversion but it can take one to two years for an S&P 500 peak after an inversion.”


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