Deadly Accurate Recession Indicator Just Went Off
Start off every day with a smile, said W.C. Fields — “and get it over with.”
Thus we force a grin to start today’s reckoning, here expressed verbally:
The stock market did not lose one solitary point today.
Our duty to Mr. Fields now discharged in full, we proceed with a scowl…
The exchanges were closed today in honor of the nation’s late 41st president, George Herbert Walker Bush.
Hence no losses today. Hence our insincere, dutiful smile.
But investors are still mourning for the money they lost yesterday.
The Dow Jones hemorrhaged 799 calamitous points — its fourth-worst single-day point loss in history.
Both the S&P and Nasdaq absorbed murderings on similar scales.
Partly responsible were comments issuing from the West Wing of the White House.
“I am a Tariff Man,” said Trump.
His chief economic man also expressed doubts about a Chinese trade deal before the 90-day “truce” lapses.
But it was not trade news alone that panicked the horses yesterday.
A Bloomberg Op-Ed gives the overview:
“The U.S. Yield Curve Just Inverted. That’s Huge.”
What is the yield curve, precisely? And why is its inversion “huge”?
Come sit down before our campfire… and prepare for a strange tale of time…
The yield curve is simply the difference between short- and long-term interest rates.
Long-term rates normally run higher than short-term rates.
It reflects the structure of time in a healthy market.
The 10-year yield, for example, should run substantially higher than the 2-year yield.
For the reasons we needn’t look far…
The 10-year Treasury yield rises when markets anticipate higher growth — and higher inflation.
Inflation eats away at money tied up in bonds… as a moth eats away at a sweater.
Bond investors therefore demand greater compensation to hold a 10-year Treasury over a 2-year Treasury.
And the further out in the future, the greater the uncertainty.
So investors demand to be compensated for taking the long view.
Compensated, that is, for laying off the sparrow at hand… and willing to accept the promise of two in the distant bush.
But when the 2-year yield and the 10-year yield begin to converge, the yield curve flattens… and time compresses.
When the 10-year yield falls beneath the 2-year yield, the yield curve is said to invert.
And in this sense time itself inverts.
Time steps all over itself, staggered by a delirium of conflicting signals.
The signs that point to the future lead to the past. And vice versa.
In the wild confusion, future and past collide… then run right past one another.
They end up switching places.
Thus an inverted yield curve wrecks the market structure of time.
It rewards pursuit of the bird at hand greater than two in the future.
That is, the short-term bondholder is compensated more than the long-term bondholder.
That is, the short-term bondholder is paid more to sacrifice less… and the long-term bondholder paid less to sacrifice more.
That is, something is dreadfully off.
An inverted yield curve is a nearly perfect omen of lean days ahead.
It suggests an economic winter is coming… when investors expect little growth.
Since 1955, an inverted yield curve has accurately forecast all nine U.S. recessions.
Only once did it holler wolf — in the mid-1960s.
It has also foretold every major stock market calamity for the past 40 years.
The yield curve last inverted in 2007.
2007, the calendar confirms, immediately preceded 2008.
Prior to 2007, the yield curve last inverted in 1998.
Recession was not far off.
Warns Paul Hickey, co-founder of Bespoke Investment Group:
When it comes to an inverted yield curve, anyone who ignores its economic message should do so at their own peril.
And now, late in 2018…
This doomy portent drifts once again into view…
From The Wall StreetJournal:
For most of this year, both short- and long-term bond yields rose as government bond prices fell across the board [bond prices and bond yields move in opposite directions]… The pattern indicated both the short- and long-term growth outlooks had improved…
That is no longer true. Now, the yield curve is closer to inverting not because short-term economic indicators are improving, but because longer-term rate expectations are falling.
Yesterday the yield curve inverted… for the first time since July 2007.
Rather, a portion of the yield curve inverted yesterday for the first time since July 2007.
The 5-year Treasury yield dipped beneath the 2- and 3-year yields.
Combined with trade war fears, here is your explanation for yesterday’s blood-and-thunder collapse of the Dow Jones.
But we have yet to see a complete yield curve inversion…
A full inversion occurs when the 10-year Treasury yield slips beneath the 2-year yield.
On this segment of the yield curve all eyes center.
How close is the full inversion?
“I would say we are perilously close,” says Mitch Goldberg, president of ClientFirst Strategy — his voice cracking a bit.
The spread between 2- and 10-year Treasury yields has now converged to 0.11% — its lowest spread since 2007.
Below you have the graphic history of yield curve inversions, stretching to 1980.
Each preceded trouble. And as you can see at the lower right… trouble brews once again:
But when can you expect the complete inversion?
The Federal Reserve will likely raise its fed funds rate two weeks from today, Dec. 19.
This rate impacts shorter-term instruments like the 2-year Treasury greater than longer-term instruments like the 10-year.
Another rate hike would put upward pressure on the 2-year yield… and just may invert the yield curve.
Market analyst Daniel Amerman:
So all it potentially takes is the Fed following its publicly stated game plan of increasing rates by another [0.25% in December], with that continuing to have a larger impact on short-term than long-term rates, and that could be enough to produce an inverted yield curve by the end of 2018.
Does that mean you can expect the curtain to come down early next year?
It does not.
History reveals the awful effects of an inverted yield curve do not manifest for an average 18 months.
Assume for the moment that the pattern holds.
Assume further that the yield curve inverts later this month.
The economy may therefore peg along another 19 months.
Then it comes to rough business… sometime in mid-2020.
Or it can all collapse in a heap tomorrow.
But given the wild economic distortions the Federal Reserve has worked these past 10 years, the thumping could shatter all existing records.
Are you sure you want to hike rates in two weeks, Mr. Powell — or next year — or the year following?
Managing editor, The Daily Reckoning