Uncategorized, Weekly Update

The Dreaded Yield Curve Inversion

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Published August 16, 2019


Like a surfer bounced by wave upon wave, investors were hit this week by a second wave. After a one day burst of market joy as the Trump Administration dialed back the September 1st imposition of trade tariffs, the U.S. Treasury bond market was rocked by a deeper reduction in yields. This time, the drop in yields on 10-year U.S. Treasury bonds was enough to push them below the yield on 2-year bonds. So, lending money to the U.S. government for 10 years actually paid you LESS than lending money for only two years. That just ain’t right. And it sent markets into a full-on selloff as such an occurrence has, in the past, been a very clear harbinger of an impending recession. But how impending? And does it really mean the stock market is doomed? The article below from Mark Decambre at Marketwatch.com gave investors some hope in answer to those questions.

Herewith is Mark’s note:

Wall Street’s most widely watched gauge of the yield curve’s slope, the spread between the 2-year Treasury note yield and the 10-year inverted Wednesday morning, flashing the clearest signal to date that the U.S. is set to face an economic recession, but that doesn’t have to mean doom and gloom for stock investors.
The U.S. 2-year Treasury note yield briefly traded above the 10-year Treasury note yield for the first time in over a decade (see chart).

Spread between 2-year note and 10-year note

The so-called inversion of the main measure of the yield curve, or a negative spread between short-term and long-term yields, has preceded the last seven recessions.

However, history shows that an inversion, while not an upbeat sign about the coming state of the economy, doesn’t necessarily translate to a lasting selloff in equity markets.
The durability of the stock market is a point lost on investors so far. This week, all major U.S. stock indexes have traded lower on the yield inversion news. But over the longer stretch, stocks have tended to rise firmly following the closely watched recession alarm.

Yield Curve Inversion

On average, the S&P 500 has returned 2.5% after a yield-curve inversion in the three months after the episode, while it has gained 4.87% in the following six months, 13.48% a year after, 14.73% in the following two years, and 16.41% three years out, according to Dow Jones Market Data (see table below):

Returns after a yield-curve inversion

Data from LPL Financial also corroborate the tendency for markets to punch higher in the long term.

Yield-curve inversion doesn’t instantly result in an economic recession

On top of all that, a yield-curve inversion, doesn’t instantly result in an economic recession. From 1956, past recessions have started on average around 15 months after an inversion of the 2-year/10-year spread occurred, according to Bank of America Merrill Lynch.

Market Update

Investors endured another week of extreme volatility pinned between global growth concerns and the prospect for further interest rate reductions. Monday saw stocks slide -1.2% with a variety of global concerns weighing on investors, including the ongoing political protests in Hong Kong. A delay in the September 1st imposition of trade tariffs on China by the U.S. cheered markets Tuesday. Stocks recouped Monday’s losses and then some, rising +1.5% with oil prices surging +4% on the news. It was a one day wonder though as stocks resumed the selling Wednesday. A drop in market interest rates to the point where 2-year U.S. Treasury yields were below 10-year yields – the so-called yield inversion – sent investors fleeing risk assets like stocks. Interest rates were reacting to a reported decline in German GDP alongside the weakest report on Chinese industrial production in 17 years. Fears of an impending global economic recession took hold in the stock market sending stocks tumbling by -3%. While stocks looked set to continue the selloff before the market open, once the bell rang stocks found buyers. A strong U.S. retail sales report coupled with good earnings from Walmart (WMT) to provide investors something positive to respond to. Stocks closed higher by only +0.3% though. The bounce gained momentum Friday with solid earnings from semiconductor firm Nvidia (NVDA) helping investors see things in a brighter light. Stocks pushed higher by +1.4% on the day while the spread between 2 and 10-year U.S. Treasury yields returned to normal.

An extremely volatile week for markets left stock indexes with only a -0.95% loss in the benchmark S&P 500 (SPY), the second consecutive week where buyers have stepped in to prevent the bottom falling out of the stock market. The Nasdaq 100 (QQQ) did even better, trimming its weekly downdraft to -0.54%. Small-cap stocks (IWM) continued their relative struggle closing lower by -1.32% for the week.

Warm wishes and until next week.