Inversion Confusion

August 27th, 2019 by Jonathan Chatfield, CFA

On August 14, the classic inverted yield curve (10-year treasury yields lower than 2-year treasury yields) reared its ugly head for the first time in over a decade. Since then it has flashed warning signs several times. So far the inversions have only occurred temporarily on an intraday basis with the inversion ending before the end of the day

However, when we look at the 90-day T-bill, we see an inversion that has persisted much longer and is an indication that the market expects the Fed to lower rates going forward. While the classic yield curve inversion has not yet existed on an end of day basis, rates on the 90-day t-bill have been above the 10-year treasury rate for several months. This phenomenon started in March and has been reoccurring since May. The spread between the 10-year and 3-month Treasury has been negative (10-year lower) for much of the 2nd and 3rd quarters.

The confusion lies in the fact that the press has been referring to the “inverted yield curve” over the past several months as a recession predictor. In fact, the normal definition of an inverted curve (which is the 10-year – 2 year spread) has NOT been inverted other than intra-day (although it has flattened). An inversion of the 10-year and 2-year yields has predicted all recessions since 1955. So although the press has been making investors nervous, the official indicator (based on closing prices and yields of treasury securities) has not yet really triggered.

As usual, market pundits have varying opinions on the subject. Some say the escalating trade war with China has caused the Fed to act to lower rates and combat the negative effects of the tariffs on the U.S. economy, which is sparking recession fears. Others say external forces are at work, artificially driving Treasury prices higher (yields lower) as overseas investors pile into treasuries. This is likely due to negative yields at home while the U.S. economy and stock market are strong, continuing to post modest growth and fair relative valuation.

At Anchor Bay we have taken a cautionary approach. The economic recovery is long in the tooth and stocks are priced near record levels. We have taken this opportunity to cut back on our equity exposure in light of the risk of economic slowdown and resulting earnings pressure on stocks.

While we are optimistic that low interest rates will provide economic stimulus and support further economic growth, we believe it is prudent at this time to reduce equities exposure and wait for indicators to give us the next signal.

Stay tuned.

LATE UPDATE (8/27/19): As of the time of this posting the yield on the 10-year Treasury has fallen below that of the 2-year Treasury on an intraday basis. The market is telling the Fed to lower rates. Meanwhile the consumer confidence numbers reported this morning, although marginally lower, remain strong.