Inverted yield curve, trade war and tariffs introduce a dose of fear into the markets.
Yield curve inversion was all over the news in the last week. An inverted yield curve can be one of the predictive indicators for a recession, and the flavor of the day is the 10-Year Treasury minus the 3-Month Treasury. But this flavor is, in fact, inverted, and the 3-Month Treasury has a higher yield than the 10-year Treasury.
The problem now, is knowing which treasuries we are supposed to look at.
This is in fact a warning sign for the economy. However, it is not as surprising as one might be tempted to think. Only a couple months ago, markets were excited about a pending end to a trade war with China. Today, we are worried about a trade war on multiple front. This has introduced a dose of fear into the market, which can be seen in the negative returns across equity indexes last month.
While initially investors hoped that President Trump could rescue the market from further damage by negotiating a tough deal with China, Europe, Canada and Mexico, that hope seems to be declining rapidly. With the President announcing new tariffs on Mexico only last week, that may not happen the way many hoped.
Considering these events, it is not a surprise that investors have purchased longer term treasuries in large enough quantities during May to drive yields below the short maturity Treasuries. One word of caution can be the fact that inverted yield curves can be false as they were in the mid-60s and even in 1998. In both of those cases, the markets continued to gain for years afterwards. Here is a chart that shows the 10-Year Treasury minus the 3-Month Treasury Yields going back almost 60 years.
Truthfully, we have been in an extraordinarily long expansion cycle marked by extraordinarily low yields in bonds. That doesn’t mean that we should ignore this indicator. What it means is that we should be cautious of two possible extremes; believing this is not a meaningful piece of information or interpreting this as “the sky is falling” can lead to mistakes.
We choose to look at this considering other evidence. That evidence includes several macro-economic indicators that warrant caution but not necessarily an impending recession. That means the risk of yet another correction is very high. The risk of recession is too early to tell.
Despite the huge rally in markets after the last correction, our indicators have remained mixed. This can often happen this late in an economic cycle. For those with longer time-horizons it is a good idea to still talk to your adviser about what strategy you have in the case of further declines that could develop as the geopolitical risks rise.
Of course, should a positive resolution surprise us, markets would be expected to rally very strongly at this point. Both possibilities exist, which is why now is the best time to make sure you are satisfied with your strategy. If we get to crisis, it is often too late to be effective in changing course.
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