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Dow Flatlines While Fed’s Recession Alarm Screams

Last Updated September 23, 2020 1:34 PM
Ben Brown
Last Updated September 23, 2020 1:34 PM
  • The Dow Jones Industrial Average (DJIA) raced to a new all-time high before suffering a sharp reversal.
  • Traders are seemingly ignoring the Federal Reserve’s own recession indicator as the yield curve inverts again.
  • Fed Chairman Jerome Powell sounded upbeat in a testimony today but refused to downplay the potential economic impact of the coronavirus outbreak.

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%.

Fed recession indicator
The New York Fed uses the Treasury bond yield spread to calculate a 37% chance of recession in July 2020. | Source: New York Federal Reserve, Board of Governors of the Federal Reserve; National Bureau of Economic Research.

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 .

Dow jumps to record high before suffering sharp reversal

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.

dow jones, stock market
The Dow reversed sharply from its daily highs. | Source: Yahoo Finance

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 bond market yield curve inverts… again

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.

Bloomberg yield curve inversion
The 3-month to 10-year spread on U.S. Treasuries turns negative again. | Source: Bloomberg

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.

Is a Dow Jones crash imminent?

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.

stock market vs yield curve inversion
In the past, yield curve inversions have trigged a stock market selloff. Not this time. | Source: Sven Henrich, founder of Northman Trading

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.

Federal Reserve’s Jerome Powell testifies before the House

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:

trump economy tweet
Source: Twitter 

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.