Global stocks fell on Wednesday, plagued by a flattening yield curve that sparked concerns about an economic slowdown in the United States and weakening expectations of a lasting U.S.
In an "economic letter" published by the San Francisco office of the U.S. Federal Reserve (Fed), Michael D. Bauer and Thomas M. Mertens summarize the implications of an inversion succinctly: "Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve". Conversely, the longer the money is invested, the higher the interest rate to offset the additional risks, especially inflation.
Weakening global growth, trade-war fears, higher interest rates, and wariness over the extent of Federal Reserve tightening are weighing on markets. No surprise, then, that one investor calls an inverted yield curve a "harbinger of doom".
According to the San Francisco Fed, each of the nine US recessions that have occurred since 1955 came between six months and 24 months after a an inversion in the yield curve of two-year and 10-year Treasury yields. The benchmark 10-year yield clung to an 11-basis-point margin over its two-year counterpart, although it was the smallest in over a decade.
But it's worth asking why the yield curve is such an uncanny predictor of recessions (and no, it's probably not different this time).
No, at least not yet.
Far from the US facing trouble, however, New York Fed President John Williams said on Tuesday the economy is strong and the base case outlook is for rate increases to continue through 2019. Shanghai markets .SSEC fell 0.6 percent, their losses limited by Chinese officials expressing confidence that a trade deal would be clinched on time.
Market watchers also say they won't get anxious until a more important part of the yield curve flips. If the trend in the graph below continues, there could be a two-year/10-year yield curve inversion by the end of 2018.
The yield curve inversion and comments from Fed speakers are causing investors to rethink the potential of a recession or if rate hikes are nearing the top, said Minh Trang, senior FX trader at Silicon Valley Bank in Santa Clara, California. Of course, that's still "pretty doggone tight", said Randy Frederick, vice president of trading and derivatives at Charles Schwab. A year ago, the cushion was at 0.62 percentage points. That is to say, almost everyone is convinced the two-year to 10-year if not the 3-month to 10-year spread will invert. It was the first part of the Treasury yield curve to invert since the financial crisis, excluding very short-dated debt. "If twos and 10s invert between now and December 18, the Fed is going to have to take out some of the hikes next year, or they should do it", said Joseph Lavorgna, chief economist of the Americas at Natixis. There have also been false positives in the past, where the yield curve has inverted but no recession has followed, such as in 1966.