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Inverted Yield Curve Mania Strikes Again!
Three Reasons to Take it in Stride
(NOTE: This is a partial repeat of an earlier NN on the Inverted Yield Curve/IYC)
The stock market dropped 800 points (-3%) on Wednesday, August 14th (also my birthday), its worst day of 2019. The big move down was in response to something Ned's Notes has addressed twice before: The dreaded Inverted Yield Curve (IYC).
Here is exactly what happened: For a brief moment on Wednesday, the yield on the 10-year treasury note fell .01% below the yield on the 2-year note. The yield curve had been flattening for some time. The inversion did not last long. By the the end of the day the situation had reverted to norm, with the 2-year treasury (1.592%) yielding slightly less than the 10-year (1.596%).
Back in April, NN reported how, for the first time in nearly twelve years, the yield (or interest rate) on long-term 10-year U.S. Treasury Bonds had briefly fallen below the short-term yields of 3-month and one-year Treasury Bills. The stock market threw a tantrum in May but then recovered all those losses and more in June and July.
NN said this back in April:
Is NN saying that “this time is different”? Absolutely not. That phrase has preceded many a disaster. However, the major problem with using this or any other indicator as a sure-fire market signal is timing. As the table below shows, the returns sacrificed while sitting on the sidelines awaiting the "recession prediction" to (maybe) come true could well be more costly than the actual losses incurred.
Indeed, according to Bank of America Merrill Lynch, post-1956 recessions have started on average around 15 months after an inversion of the 2-year/10-year spread occurred.
Here are three additional other reasons why the IYC is (most likely) noise rather than (at least not yet) a signal:
1) Trillions of dollars in negative bond yields in Europe and Japan are driving yield-starved investors to the U.S.,depressing long-term Treasury yields. This is distorting the US bond market and pushing yields lower than they would normally be.
2) Some say the IYC reflects expectations of coming decreases in interest rates by the Federal Reserve. This anticipation may be driving long-term bond yields below their short-term peers. If the Fed cuts rates in a speedy fashion, a recession may well be avoided and the IYC turn out to be a false positive.
3) Some Fed policy makers have openly questioned the emphasis on the yield curve, seeing it as only one data point among many that could indicate economic distress. Meanwhile, the underlying fundamentals of the economy are sound, personal and corporate balance sheets are generally in good shape, and financial market activity, such as IPOs and lending, is robust.
Ned’s Notes Takeaway: It's been more than ten years since the last recession. We know (with not quite absolute certainty) that another one will come. But we don't know when that time is. Though an inverted yield curve will certainly precede a recession, an IYC is not a fool proof signal of imminence. Said another way, an IYC is always a precursor to a recession, but not every IYC is followed by a recession. Investors are therefore likely better off holding fast now and through a recession (should one come), because trying to time the market just right is a nearly impossible task.
Email with questions or comments: Nedmoore@bey-douglas.com
Addendum: Ned's Notes is a proprietary newsletter created by none other than Ned. Feel free to forward it to others as you like but its contents may not be used for commercial purposes without the express consent of the author.
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