What A Yield Curve Inversion Means For Traders

This Market Indicator That Frequently Signals a Recession Just Flashed Red

This Market Indicator That Frequently Signals a Recession Just Flashed Red

Asian stocks fell on Wednesday, dragged by Wall Street's tumble as sharp declines in long-term US Treasury yields and resurgent trade concerns stoked investor worries about global economic growth.

"Investors are coming around to our downbeat view of the prospects for the USA economy", analysts at Capital Economics wrote on Tuesday, arguing that there was no reason to regard this pending yield curve inversion as different from others.

According to the San Francisco Fed, each of the nine USA recessions that have occurred since 1955 came between six months and 24 months after a an inversion in the yield curve of two-year and 10-year Treasury yields.

However, investors are increasingly concerned by a flattening of the spread between 2-and 10-year Treasuries, a more fundamental benchmark of market health. Upon closer scrutiny, investors said a deal between the world's two biggest economies was far from a sure bet.

"The market decline in the US overnight and the flattening of the yield curve reflect that economic growth momentum is taking over as the primary concern for investors, even as the latest ISM manufacturing data is holding up well", wrote Tai Hui, market strategist at J.P. Morgan Asset Management. It has preceded all nine USA recessions since 1955.

Concerns about slowing USA growth have accelerated the flattening of the yield curve, a phenomenon in which longer-dated debt yields fall faster than their shorter-dated counterparts. It's a sign investors are unmoved by a potential slowdown in the Federal Reserve's interest-rate-hiking program. It may take two rate hikes or more for that portion of the curve to invert. "While the current environment is somewhat special-with low interest rates and risk premiums-the power of the term spread to predict economic slowdowns appears intact", their paper said. Most of the time, banks demand higher interest for longer periods of time (cuz who knows when they're gonna see that money again?!).

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Tuesday's markets chaos came a day after equities boomed on optimism that China and the USA had temporarily called a tariff ceasefire to sort out their trade dispute. Rather, I suggest there should not be a Fed at all and interest rates should be left to the free market.

As of writing, the 10-year bond yield was down 2.65% at 2.912%, the 5-year bond yield was losing 1.83% at 2.787%, and the 2-year bond yield was dropping 1% at 2.805%.

That hardly ensures that a recession is coming, let alone one as severe as the Great Recession a decade ago. "The European bond market was already preparing for trouble ahead". On Tuesday, the Dow Jones Industrial Average fell almost 800 points, or 3.1%, largely in response to recession fears stoked by recent changes in the yield curve.

"The U.S. economy is likely to be able to withstand another rate hike or two, therefore, the flattening of the Treasury curve looks a little over done". If the trend in the graph below continues, there could be a two-year/10-year yield curve inversion by the end of 2018.

"The curve has to invert and it's going to happen sooner than people think. If twos and tens invert between now and December 18, the Federal Reserve is going to have to take out some of the hikes next year-or they should do it", Joseph Lavorgna, chief USA economist at Natixis, told Reuters. "I'm anxious that they won't".

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