Global stock markets dropped sharply today with the Dow, S&P 500 and NASDAQ each falling more than 3%. The catalysts appear to have been concerns over the truce in the trade war between the United States and China, uncertainty over the outcome of Brexit, and an inversion along part of the Treasury yield curve.
Normally, when an economy is healthy, yields on longer-term Treasury bonds are higher than those on shorter-term bonds – compensating investors for both future growth and inflation. This spread is known as the term spread – the difference between long-term and short-term interest rates. When this relationship flips and yields are higher on shorter-term than longer-term Treasury bonds, the yield curve has “inverted”.
According to research from the Federal Reserve Bank of San Francisco, using the term spread between the 10-year and 1-year Treasury bonds, every recession of the past 60 years has been preceded by an inverted yield curve (i.e. the interest rate yield on the 1-year exceeded that of the 10-year). As noted by the researchers: “A simple rule of thumb that predicts a recession within two years when the term spread is negative has correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession. The delay between the term spread turning negative and the beginning of a recession has ranged between 6 and 24 months.”
Yesterday, for the first time since 2007, yields on both the 2-year and 3-year Treasury bonds exceeded the yield on the 5-year Treasury bond, creating an inversion. However, the more closely watched rate differential as a potential indicator of pending recessions – between the 2-year and 10-year Treasury bonds – has not inverted.
As noted above, recessions do not necessarily fall immediately on the heels of an inversion and can be more than two years away. Over that time period, stocks have historically continued to rally. Additionally, other standard recession indicators such as unemployment, jobless claims, corporate earnings and inflation expectations are not signaling recession. It is near impossible to predict the exact timing of a recession and it is for this reason that we maintain longer-dated Treasuries in our portfolios as a partial hedge. When rates drop overall as they did today, the value of your Treasury bonds increase, particularly those with longer maturities, helping to offset declines in the stock markets. We continue to monitor the fundamental and technical factors that impact the economy and the markets and will make adjustments to the portfolios as appropriate.
Please note that the US stock and bond markets are closed tomorrow in memory of President George H.W. Bush.
We will be communicating with more detail in the coming days but do not hesitate to contact us if you have any questions.
- Economic Forecasts with the Yield Curve, Research from Federal Reserve Bank of San Francisco
- Market Watch: Stock investors should not fear the inverted yield curve, strategist says
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