Beware – the yield curve is inverting

One of Wall Street’s most reliable signals of danger in the markets is flashing. Is it time to worry, asks Marina Gerner.

926-shopping-634

"One of Wall Street's most reliable fortune tellers is flashing ominous signals," says CNN. All eyes have turned to the yield curve. Investors are fretting about whether it's going to "invert," which is seen as a harbinger of trouble. Since World War II, every recession has been preceded by an inverted yield curve.

The yield curve plots the difference, or spread, between the yield on the ten-year US Treasury (government bond), and the yield on the two-year Treasury. It therefore shows how much it costs the US government to borrow money over ten years, compared to two years. In normal times, the interest rate on loans rises with the lending period, so the yield curve slopes upwards.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

The yield curve inverts when long-term interest rates fall below the level of short-term ones. This means investors are pencilling in a downturn that will prompt the central bank to cut interest rates. Inversion hasn't occurred yet, but it's getting uncomfortably close.

The canary in the coalmine

The yield curve has flattened sharply recently. The more closely monitored spread between two and ten-year yields is still positive, but the two- and three-year yields are now above five-year ones for the first time since 2007. At its post-2008 financial crisis peak that two-ten year gap was 2.9% as the economy pulled out of recession, say Joe Rennison and Robin Wigglesworth in the Financial Times. Now, it has slipped below 0.1% for the first time since 2007. "It seems... only a matter of time before the benchmark measure also inverts, says Tom Stevenson in The Daily Telegraph. "The canary may still be clinging to its perch, but it's getting breathless."

Advertisement
Advertisement - Article continues below

But does that mean a recession is imminent? No. "Even if the yield curve inverts further, the economy is likely to continue performing well in the short-term," says Michael Pearce on Capital Economics. As Rennison and Wigglesworth point out, US economic growth in the third quarter was strong, unemployment and wage growth data are positive, and US investors and policy makers are still upbeat. The oil price drop has boosted households' purchasing power, which will keep consumption strong in the short run. S&P 500 companies are still set to boost profits next year, says Michael Mackenzie in the FT.

Too soon to panic

There has been one occasion in the 1960s when the yield curve inverted but a slowdown ensued, not a recession. And while a recession occurred on all the other occasions, it did so "with a sizeable lag," as Stevenson notes, on average two years after the inversion. So this near-inversion may simply be one further sign that the bull market is on its last legs. "Just as the bond market foretold in 2000 and 2006, there is a growing wariness of late-cycle weakness, marked by plenty of corporate debt," says Mackenzie. In any case, the yield curve is worth watching given its power to unnerve the markets.

... but the death cross' is nothing to fear

"In all the squiggly charts that traders see every day, recognisable patterns occasionally emerge," says Jason Karaian on Quartz. One of the patterns that spooks investors is the "death cross," when an index's short-term moving average drops below its long-term moving average when both are declining. Commonly it refers to the 50-day average falling below the 200-day average. The death cross is supposed to reflect dwindling momentum and herald further falls. The opposite is called a "golden cross," supposedly a classic "buy" signal.

926-markets-634

On 7 December, both the S&P 500, America's blue-chip index, and the Russell 2000, the main gauge of small companies' share prices, formed a death cross. The S&P slipped by 2.3% after two previous days of falls. That pushed its 50-day moving average four points below its declining 200-day moving average, leading to the first death cross since January 2016.

But the death cross has not been a good bear market indicator. "Like all technical indicators, it has its limits," says April Joyner on Reuters. Far from all large market sell-offs have been signalled by a death cross. Crucially, there was no death cross before the financial crisis. However, there have been four S&P death crosses since then. The death cross only correctly presaged further equity falls ten times out of 22 incidents since 1970, according to Tan Kai Xian and Will Denyer of Gavekal Research.

Meanwhile, US asset management group Fisher Investments UK notes death crosses in equity markets worldwide occurred in 2004, 2006, 2011, 2015, 2016, 2017 and 2018 all global bull market years. As Xian and Denyer put it: "We... would advise investors not to get unduly focused on tea leaf gazing".

Advertisement

Recommended

Visit/519858/how-long-can-the-good-times-roll
Economy

How long can the good times roll?

Despite all the doom and gloom that has dominated our headlines for most of 2019, Britain and most of the rest of the developing world is currently en…
19 Dec 2019
Visit/517688/the-british-equity-market-is-shrinking
Stock markets

The British equity market is shrinking

British startups are abandoning public stockmarkets and turning to deep-pocketed Silicon Valley venture capitalists for their investment needs.
8 Nov 2019
Visit/516944/why-wall-street-has-got-it-wrong-again
Economy

Why Wall Street has got the US economy wrong again

The hiring slowdown does not signal recession for the US economy. Growth is just moving down a gear, says Brian Pellegrini.
25 Oct 2019
Visit/511212/reasons-for-investors-to-be-bearish-but-stick-with-the-stockmarket-bulls
Stock markets

There are lots of reasons to be bearish – but you should stick with the bulls

There are plenty of reasons to be gloomy about the stockmarkets. But the trend remains up, says Dominic Frisby. And you don’t want to bet against the …
17 Jul 2019

Most Popular

Visit/investments/stockmarkets/600909/will-coronavirus-kill-off-the-bull-market
Stockmarkets

Will coronavirus kill off the bull market?

It seems clear now the coronavirus will at some point go global. And when it does, will it bring down the stockmarket’s bull market? John Stepek looks…
27 Feb 2020
Visit/investments/commodities/gold/600887/gold-price-coronavirus-cost-of-face-masks
Gold

Gold, coronavirus, and the high cost of face masks in northern Italy

The price of gold is spiking – as it always does in a global panic. But this bull market predates the coronavirus epidemic, says Dominic Frisby, and w…
26 Feb 2020
Visit/personal-finance/pensions/pension-tax/600877/why-it-makes-sense-to-scrap-higher-rate-pensions-tax
Pension tax

Why it makes sense to scrap higher-rate pensions tax relief

The point of pensions tax relief is to keep you out of the means-tested benefits system. The current system is ridiculously generous, says Merryn Some…
24 Feb 2020
Visit/517625/tr-european-growth-trust-why-investors-shouldnt-overlook-europe
Sponsored

Why investors shouldn’t overlook Europe

SPONSORED CONTENT - Ollie Beckett, manager of the TR European Growth Trust, tackles investor questions around Europe’s economic outlook and the conseq…
6 Nov 2019