How long can investors continue to ignore the inverted yield curve? The 'recession indicator' has preceded every stock market correction in modern history.
The S&P 500 and Nasdaq topped out at record highs in yesterday’s session, and the Dow Jones briefly followed suit today. The DJIA shot to a new zenith before flatlining around midday.
Despite the record figures, there’s a silent alarm going off: the dreaded yield curve inversion. The Federal Reserve uses this indicator to calculate the probability of a recession. And right now it’s flashing red, putting the chance of recession this year at 37%.
Historically, this indicator has preceded every major recession. The timing couldn’t be worse for the Federal Reserve whose chairman Jerome Powell testified before the House Financial Services Committee today.
Following a strong day on the stock market yesterday, the Dow Jones Industrial Average plowed to a new all-time high above 29,415. But the index reversed those gains as the session matured.
Shortly before 12:30 pm ET, the Dow had gained just 32.02 points or 0.11% to trade at 29,308.84.
The S&P 500 and Nasdaq were up 0.43% and 0.56%, respectively.
Gold failed to capitalize on the Dow’s risk-off pivot. The price of the yellow metal plunged 0.6% to $1,569.80.
The yield curve inversion happens when long-term bonds give out less than short-term bonds. In this case, the ten-year U.S. Treasury bond yields less than the three-month. The yield curve inverted between May and September last year, and flipped negative again in late January 2020.
Why is this a big deal? The indicator is used to predict a recession because it signals a flight to “safe” assets and investor pessimism about the long-term economy.
In a grab for safety and duration, everyone is going for U.S. Treasuries – Gregory Faranello, AmeriVet Securities in New York
The Federal Reserve tracks this inversion closely. Based on the current spread, it calculates a 37% probability of a recession in July this year.
Maybe not. The indicator has been historically accurate in predicting stock market corrections, but it doesn’t do a good job of predicting when the reversal comes.
In fact, there may be no reversal at all. As you can see in the chart below, traders have completely brushed it off this time around. In 2000 and 2007, the yield curve inversion was quickly followed by a stock market crash. This time? It just keeps pushing higher.
Analysts have pointed to the fact that the U.S. economy is fundamentally strong. And the inversion may say more about weakness abroad rather than recession panic at home.
The yield curve inversion is a signal now of global growth issues, and not really reflecting what is going on in the U.S. – Faranello.
The yield curve inversion was likely on Jerome Powell’s mind as he headed to Capitol Hill today. The Fed chairman delivered a testimony before the House Financial Services Committee, where he was grilled about the impact of the coronavirus.
Reuters reports that Powell told Congress that the outbreak – which has now surpassed 43,000 cases worldwide – is “very likely” to have an impact on the U.S. economy.
The problem, Powell said, is that no one knows how severe that impact will be:
The question we will be asking is will these be persistent effects that could lead to a material reassessment of the outlook.
Beyond the impact of China’s slowdown seeping into the global marketplace, the potential for a widespread U.S. coronavirus outbreak looms large. Just yesterday, the San Diego Union-Tribune reported that a coronavirus patient had been accidentally discharged from the hospital due to a botched test.
Despite this threat, Powell said the economy was in a “very good place” and “performing well.”
President Trump was less circumspect in his Tuesday morning tweet:
But traders aren’t so sure. Those nerves are playing out on the futures market where traders are pricing in a 57% chance of a rate cut in July. That figure rises to 68% for September.
In other words, the Fed may be forced to cut rates to support the economy if the virus doesn’t slow down.
With additional reporting by Josiah Wilmoth.