The U.S. bond market just flashed what could be its biggest warning yet of a coming recession, and it is not alone.
The spread between the 2-year Treasury yield and the 10-year yield flipped so that the 2-year is now higher than the benchmark 10-year yield for the first time since June, 2007. Other parts of the curve have already inverted, but traditionally the 2-year to 10-year spread is the most widely watched by market players.
The U.S. 30-year bond yield fell to a record low early Wednesday, touching 2.01% for the first time ever, falling through its prior record of 2.08. Yields across Europe fell, and the German 10-year touched anew low of negative 0.65%.
An inverted yield curve has been a reliable recession indicator, but it does not always precede a recession and the length of time before a recession occurs has varied. According to Credit Suisse, the average length of time since the late 1990s for a recession to occur after inversion was 22 months.
“The bond market is screaming recession…Just take a look at what the U.S. market is doing,” said National Alliance’s Andrew Brenner. “As I look at the European curve, you’re at record lows across the board…I think the key things today were Germany did show a contraction in their GDP, and the Chinese numbers were weaker – retail sales down by 11%, the industrial production off by 20%.”
Strategists say in order to signal recession, the yield curve cannot just flip in and out of inversion, but it needs to stay there for some time to be meaningful. Because other parts of the curve are inverted, this signal is viewed as fairly strong.
For now, the Fed is getting the blame for the recession warning, with many investors fearing the central bank could make a policy mistake by cutting rates too slowly to respond to uncertainties about growth.
“The yield curve does not necessarily mean there’s a recession. A lot will depend on the Fed. And as I have argued the Fed has raised rates too much,” said Joseph LaVorgna, Natixis chief economist, Americas. “Mr. Powell should act more aggressively to respond to this inversion. The sooner they act, the better. A yield curve inversion now is telling you a recession is probably eight quarters away.” LaVorgna said he expects the time frame is lengthening
Fed Chairman Jerome Powell has said the Fed will be ready to cut as needed, based on concerns about sluggish global growth, the trade wars and weak inflation.
“The point is the curve is telling you that absent Fed action, growth will slow and inflation with it. It’s telling you where the direction of things is headed,” said LaVorgna. LaVorgna said last time the curve inverted it took
Strategists at BMO, said it’s clear that the market is viewing the Fed as behind the curve because of the fact that the 3-month bill yield has been higher than the 10-year yield since the Fed cut rates last month. The Fed ended its rate hiking cycle after its December hike. It then stayed on hold for months, and finally cut rates for the first time since the financial crisis at the end of July.
Just as the timing on the economy’s past moves into recession was varied, the stock market too can take take quite a while to peak after an inversion.
“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,” according to Bank of America Merrill Lynch strategists. “For the ten inversions back to 1956, the S&P 500 topped out within approximately three months of the inversion six times (1956, 1959, 1965, 1973, 1980, and 2000). The S&P 500 took 11 to 22 months to peak after the other four inversions (1967, 1978, 1989, and 2005).”
Brenner said he doesn’t see the U.S. moving into a recession, with the consumer still strong and making up 70% of the economy.
“I think the Fed will say stuff which is somewhat accomodative for the markets. As far as the U.S. economy, you have no spending limits and you have Trump, Pelosi and Schumer who agree on one thing- they all want to spend,” said Brenner.
The 2-year yield was at 1.599%, while the 10-year was at 1.586% Wednesday.
“The Fed is in a tough spot. They have a hard enough time explaining why they cut interest rates in July. If you are also seeing some solidification of core inflation, the chance is they’re less likely to cut going forward,” said Jon Hill, BMO rate strategist. Core CPI showed an unexpected pickup this week. “The market is still debating whether it’s a 25 or 50 basis point rate cut. It’s not a question of whether they’re going to cut. It’s the speed.”
BMO points out the last time the 2-year/10-year spread fell below zero fed funds were at 5.25%. The range is now 2 to 2.25% after the Fed’s July rate cut.