Updated: 08-19-2019

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Updated: 16-Aug-19  03:17PM ET
Analyst: Pat O'Hare

In case you haven't heard, the spread between the 2-yr note yield and the 10-yr note yield (2s10s) inverted on Wednesday for the first time since 2007.

In case you didn't know, an inversion in the 2s10s spread has preceded every recession since 1980.

In case you really care, the 2s10s spread isn't the most reliable predictor of recession among the different term spreads.

According to researchers at the Federal Reserve Bank of San Francisco 1, that distinction belongs to the 3-month bill and 10-year note spread (3mo10yr), which first inverted in May.

Different Day, Different Take

We have been tracking the 3mo10yr spread closely since August 31, 2018, when it stood at 72 basis points. That was shortly after the aforementioned research was published. Today, the 3mo10yr spread is inverted by 27 basis points.

What a difference, then, a year has made, but in the case of the 2s10s spread, one can reasonably say what a difference a day made.

On August 13, the spread between the two securities stood at one basis point, yet the S&P 500 advanced 1.5% that day. On August 14, the spread inverted by one basis point (briefly) and the S&P 500 declined 2.9%, as every talking head pointed out how that reversion is a leading recession indicator.

Ostensibly, the stock market sold off on 'recession concerns,' never mind that the 2s10s spread didn't close inverted and that the length of time between the first inversion in the 2s10s spread and the start of each of the five recessions since 1980 has averaged just over 18 months.

In brief, it was an overreaction to the recession line that wasn't being crossed just two basis points higher.

Warnings Signs

Presumably, Wednesday's sell-off had an algorithmic driver behind it that exacerbated the losses. That's not to say, however, that there weren't some legitimate growth concerns in the price action, and even more to the point, legitimate concerns that the U.S. economy is going to feel the contagion effect of weak growth abroad.

On the same day the 2s10s spread inverted for the first time since 2007, China reported its weakest industrial production growth since 2002 and Germany reported a 0.1% quarter-over-quarter decline in its second quarter GDP.

The contraction in the German economy is remarkable, which is why we'll remark on it. It enveloped the softness in the manufacturing economy, the uncertainty of the Brexit issue, and the nagging effects of tariff actions.

The most remarkable element of all, though, is that Germany's economy contracted despite negative interest rates and signaling from the ECB that it is likely going to provide further policy accommodation soon.

Call it a warning sign that a further relaxation in monetary policy might not do the trick every central banker is hoping it will do and that Treasury yields may not have hit bottom just yet.

The latter, though, could have more to do with what sovereign yields in Europe and Japan do, as their descent further into negative territory has been a clear precipitant for the decline in yields in the Treasury market as investors reach for positive yields that can't be found in a large part of the developed world.

This is not an unfamiliar trade. We have been highlighting it for some time. The important difference today, however, is that it is expected to have some staying power given that economic activity is weakening in the world's largest economies. Furthermore, the ECB is signaling that it is getting ready to provide more monetary policy stimulus soon.

Writing on the Wall

The Federal Reserve has been cagier about its policy path, yet the fed funds futures market looks quite certain about the Fed's policy path. It has priced in a 100% probability of another rate cut at the September FOMC meeting, a roughly 90% probability of an additional rate cut at the October FOMC meeting, and an approximately 57% probability of yet another rate cut at the December FOMC meeting.

It's an amazing outlook considering the U.S. economy remains in a growth mode, albeit without a lot of support from the manufacturing side of the economy. What that outlook portends, though, is a future deterioration in the U.S. economy that will necessitate the monetary policy support.

Why would there be a deterioration? There are myriad influences, yet the leading candidates in the market's mind include the tariff actions, which have increased uncertainty among businesses and consumers alike, and a contagion effect from economic weakness abroad.

Some say the 2s10s inversion this past week was the writing on the wall to this view. That's too trite for us knowing that several portions of the yield curve have been inverted for a while now and knowing that there has been a relentless flattening in the 2s10s spread that has served as a slow-motion bearing toward this reportedly stunning inversion. 

What It All Means

Not everyone is convinced that the yield curve is playing a leading economic role like it has in the past. This time (gulp) is different, they say, because the yield curve has been taken captive by an interest-rate differential trade. In other words, the flattening/inversion is an economic head fake.

That argument is not without merit given how the 10-year German bund and 10-year Japanese government bond have been trending. Considering their path, one can see why U.S. Treasuries have had mass appeal, but

the argument is not above reproach. The U.S. economy is not firing on all cylinders.

Business investment is soft and manufacturing activity has been weakening. Fortunately, the economy's most important cylinder - the consumer - is still running at a pretty good clip.

The question is, will businesses increase their investment activity on the belief consumer spending activity is going to remain strong or will consumers pull back on their spending, unnerved by the trade uncertainty, and, ironically, reports about what a flattening/inverted yield curve typically portends for the U.S. economy?

The answer will become known in due time, but in the meantime, the yield curve will continue to throw a curveball at anyone looking to divine meaning from it, including the Federal Reserve.

From our vantage point, we see half truths in the yield curve.

It is true that the interest-rate differential trade has played an important role in the flattening/inversion action. It is also true that there is a basis for economic growth concerns given the weakness abroad, the softening in manufacturing activity here, the blow to business confidence imposed by the tariff uncertainty, and the fading impact of fiscal stimulus.

Put those two halves together and you have a whole reason to think the economic growth risk is weighted to the downside. Accordingly, investment portfolio management should involve a shift up the quality curve for stocks and bonds alike.

--Patrick J. O'Hare, Briefing.com

1Bauer, Michael D., and Thomas M. Mertens. 2018. "Information in the Yield Curve about Future Recessions." FRBSF Economic Letter 2018-2020. (August 27)

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