Market Extra: 5 things investors need to know about an inverted yield curve



The main measure of the yield curve briefly inverted Wednesday— with the yield on the 10-year Treasury note falling below the yield on the 2-year note — and rattled stocks and other markets by underlining investor worries over a potential recession.

But while inversions are seen as a reliable recession indicator, investors may be pushing the panic button prematurely. Here’s a look at what happened and what it might mean for financial markets.

What’s the yield curve?

The yield curve is a line plotting out yields across maturities. Typically, it slopes upward, with investors demanding more compensation to hold a note or bond for a longer period given the risk of inflation and other uncertainties.

An inverted curve can be a source of concern for a variety of reasons: short-term rates could be running high because overly tight monetary policy is slowing the economy, or it could be that investor worries about future economic growth are stoking demand for safe, long-term Treasurys, pushing down long-term rates, note economists at the San Francisco Fed, who have led research into the relationship between the curve and the economy.

They noted in an August 2018 research paper that, historically, the causation “may have well gone both ways” and that “great caution is therefore warranted in interpreting the predictive evidence.”

What just happened?

The yield curve has been flattening for some time. On Wednesday, a global bond rally in the wake of weak China and German economic data pulled down yields for long-term bonds. The 10-year Treasury note yield TMUBMUSD10Y, -6.10% fell as low as 1.574%, briefly trading around 1 basis point below the yield on the 2-year note peer TMUBMUSD02Y, -5.59%.

The inversion was short-lived. In recent trade, the 10-year yield stood at 1.603%, down more than 7 basis points, while the 2-year yield was down 7.2 basis points at 1.597%, Tradeweb data show.

See: 2-year/10-year Treasury yield curve inverts, triggering bond-market recession indicator

Why does it matter?

The 2-year/10-year version of the yield curve has preceded each of the past seven recessions, including the most recent slowdown between 2007 and 2009.

Other yield curve measures have already inverted, including the widely-watched 3-month/10-year spread used by the Federal Reserve to gauge recession probabilities.

“While we don’t know is how long the 2/10 curve will remain inverted, we do know is almost everything is upsetting the markets these days, and this inversion is pushing many to the brink of losing what was a deeply-rooted optimism for economic growth and equity prices,” said Kevin Giddis, head of fixed income at Raymond James, in a Wednesday note.

Is recession imminent?

A recession isn’t a certainty. Some economists have argued that the aftermath of quantitative easing measures that saw global central banks snap up government bonds and drive down longer term yields may have robbed inversions of their reliability as a predictor. According to this school of thought, negative bond yields in Europe and Japan have forced yield-starved investors to the U.S., artificially depressing long-term Treasury yields.

Some Fed policy makers, including New York Fed President John Williams, have also periodically questioned the overwhelming importance placed by market participants on the yield curve, seeing it as only one measure among many that could point to economic distress.

Also see: Here are 3 times the Fed denied the yield curve’s recession warnings, and was wrong

Others say an inversion of the yield curve reflects when the bond-market is expecting the U.S. central bank to set off on an extended easing cycle. This pent-up anticipation drives long-term bond yields below their short-term peers. But if the Fed cuts rates in a speedy fashion and successfully prevents an economic downturn, the yield curve’s inversion this time around may turn out to be a false positive.

And even if the yield curve does point to a future recession, investors might not want to panic immediately. 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.

Read: The U.S. Treasury 2-10 year yield curve inverted and that means stocks are on ‘borrowed time,’ says BAML

Is the stock selloff overdone?

The inversion was blamed by analysts for accelerating a stock-market selloff on Wednesday, with the Dow Jones Industrial Average DJIA, -1.63% falling 420 points, or 1.6%, while the S&P SPX, -1.70%  dropped 1.4%.

But some investors argued that until other recession indicators, such as the unemployment rate, start blinking red, it’s probably premature to press the panic button.

“The underlying fundamentals of the economy are reasonably sound. The balance sheets of the household, nonfinancial and financial sectors are generally in good shape, and financial conditions are not overly restrictive,” wrote Jay Bryson, an economist at Wells Fargo Securities.

Check out: Dow tumbles more than 300 points on weak Chinese, German economic data, U.S. yield-curve inversion

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