The US could be headed for a recession soon as the market’s most closely watched part of the yield curve inverted today.
In the last 50 years, such inversion is always a precursor of a recession.
Shortly after 6 a.m. ET on Wednesday, the yield on the 10-year U.S. Treasury bond dipped below the yield on the 2-year U.S. Treasury as the 10-year fell 1 basis point below the 2-year. The yield curve inversion has a strong track record of predicting a recession; each of the last seven recessions (dating back to 1969) were preceded by the 10-year falling below the 2-year.
Ahead of the last recession, the yield curve inverted briefly as early as December 27, 2005, about two years before the financial crisis sent the economy into recession.
For over a year after that, the yield curve fluttered in and out of inversion. The last inversion, as measured by U.S. Treasury data collected by the St. Louis Fed, was in 2007.
Concerns over a global slowdown, in addition to uncertainties from the U.S.-China trade war, have weighed heavily on longer-term U.S. Treasury yields. Since the new year, the return on the longer-term 30-year Treasury has fallen from a high of 3.12% in March to 2.08% on August 14.
Bond yields across the board have come down over that same time period, as investors move funds from more aggressive-yielding securities into risk-off assets like gold and U.S. Treasuries.
Yields came down precipitously in August amid a mix of global concerns: President Donald Trump threatened new tariffs on China, an Argentinian election renewed worry over its debt crisis, and protests escalated in Hong Kong.
Morgan Stanley wrote August 12 that unless economic data or U.S. equity earnings turn around, “the bear is alive and kicking.” Their note adds that investors should be careful about equity markets, recommending staples and utilities stocks amid recession risks.
In an August 13 note, Bank of America Merrill Lynch warned that equity investors should not expect the stock market to turn sour immediately, as the S&P 500 has a tendency to experience a “last gasp rally” to a new peak after dipping.
BAML points out that it can take between eight to 24 months for a recession to hit after the 2-year and 10-year curve inverts. They warned that an inverting yield curve means equities are on “borrowed time.”
The Federal Reserve may have hoped that cutting rates in its July 31 meeting would have helped the yield curve steepen, since the shorter end of the curve closely tracks where the federal funds rate is.
The day after the Fed lowered rates, the 2-year bond did come down and widened slightly against the 10-year, extending the spread to 17 basis points.
But trade developments the Monday after clobbered bonds and began the fall into inversion, raising questions about whether or not Fed would be backed into a corner and forced to aggressively cut rates in its remaining meetings this year.