You've probably seen it. And not just on financial sites either, but front page headlines on major media outlets like Yahoo.com, Fox News, and CNN.
I'm talking about the inverted yield curve. Specifically, the fact that yields on the 10-Year Treasury (1.62%) slipped below those on the 2-Year note (1.63%). That's not the natural order of things. Anyone who has ever bought a bank certificate of deposit (CD) knows that longer-term maturities are supposed to pay more than shorter ones.
But the upward sloping yield curve has flattened out recently, flirting with inversion. And on August 14, it finally happened. There have been other yield curve inversions in recent months involving 3-Year and 5-Year Treasuries. But the 2-10 curve is the most closely watched because of its uncanny predictive abilities.
The last time this flip-flop happened was in December 2005, about two years before the Great Recession hit. We've seen this same phenomenon ahead of every economic downturn over the past 50 years. There has been a 2-10 Treasury inversion preceding all seven economic recessions since 1969.
But don't panic.
Let's just say this particular indicator is more of a "watch" than a "warning," as they say in tornado country. It simply means that conditions are favorable for an economic slump, not that one is imminent. The lag time between yield curve inversion and the onset of recession has been 22 months on average.
So, things might not get dicey until June 2021.
Looking back in history, the S&P 500 has gained 12% on average in the 12-month period following yield inversion. So, this bull market may still have some life left.
The steep drops we've seen in the market here recently are a continuation of the flight-to-quality that has seen hundreds of billions of dollars yanked from equities and deposited into safe government bonds. That fierce demand has driven prices up, causing yields to tumble across the board.
Just look at the 30-year Treasury yield. From a high of 3.1% earlier this year, it has plummeted below 2.0% -- the lowest rate on record. Still, that's downright generous compared with yields overseas, particularly in Europe. Across the pond, it's not just investors that are piling into government debt, but also the European Central Bank (ECB) through its quantitative easing program.
In many cases, that robust demand has pushed prices so far above face value that yields have been beaten down into negative territory. That's right, the premium paid on some bonds is more than the interest received until maturity, meaning investors are deliberately accepting below-zero payouts.
The 10-Year German Bund just touched a fresh low of -0.60%. That's equivalent to loaning out $1,000 today with the guarantee of getting back $994 in principal and interest. But investors (particularly those in charge of endowments, pensions and other institutional pools) have to put their cash somewhere and are often required to hold a certain percentage in government bonds.
So, they take whatever they can get -- even if that number has a minus sign in front of it.
About one-quarter of the global bond market is currently negative. Incidentally, I believe this partially explains our yield curve inversion (Uncle Sam's 10-Year rate of 1.6% looks fantastic next to Germany, France and Japan). These unusual circumstances could be giving us a false-positive recession reading.
I'll be discussing all of this in greater detail as we move forward. For now, I still believe it makes sense to take gains where appropriate and shift into more defensive asset classes.
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