The Market Today

TODAY’S NEWS

2y10y Spread Finally Inverts on Continued Flight-to-Quality: The spread between the 10-year Treasury and the 2-year Treasury turned negative for the first time of this cycle overnight, coming into this morning’s trading at -1.7 bps (6:45 a.m. CT).  The move was technically precipitated by a bull flattening move that saw 2-year Treasury yields drop 10 bps from yesterday’s close and 10-year yields drop an even larger 12 bps.  This is a key development, as we have discussed often over the past 14 months including an extension discussion in a July 2018 publication.  Not only did this key yield curve indicator turn negative, but the 30-year Bond yield dropped to its lowest level on record at 2.01%.  Following are a few contextual considerations that are key for fixed income investors.

Importance of the Yield Curve and 2y10y Spread to Economic Cycles

• During the Modern Fed Era (1982-current), an inverted yield curve has been one of the most dependable indicators of a turning economic cycle
• The yield curve has been a more timely and consistent indicator than any of the leading economic data
• Other parts of the yield curve have already inverted many months prior, including the first segment to invert, the 2y5y spread back in December
• The 2y10y spread has been the most relevant curve indicator of a shifting economic environment, according to our analysis
• The 2y10y spread has turned negative once during the Modern Fed Era which did not front-run a recession – 1998’s Asian Financial Crisis
• The 2y10y spread inverted in 1989, 2000, and 2005; all examples front-running recessions by an average of 19 months

Inflation Giving the Fed Flexibility to Respond

• During the previous 2y10y inversions which were followed by recession, the Fed continued hiking after the curve inverted out of inflation fears
• The sole inversion in which the Fed’s first post-inversion move was to cut rates was in 1998, the only inversion not leading to a recession
• The Fed has, thus far, responded to growing uncertainties with a rate cut, and forward communications that there may be more to come
• Inflation is not currently pressuring the Fed to hike
• Investors should be particularly careful when saying “this time is different” on almost any significant indicator, including the yield curve

Causality, Not Just Coincidence

• There is disagreement from analysts on the topic, but an inverted curve does appear to have some level of causality, not just coincidence
• First, it is self-reinforcing in that business leaders are likely to reign in the risk taking when a key recession indicator is flashing red
• Second, the supply-side incentive for credit creation diminishes greatly when costs of funds are higher than asset yields

Takeaways for Investors / Balance Sheet Managers

• Investors would be prudent to take into account a heightened risk of recession based on this most recent inversion
• While the current inversion appears to be more similar to 1998 than 1989, 2000, or 2006, we will now raise our recession odds from 38% to 45%
• At least part of the story is likely to be how long the curve remains inverted, and to what degree it inverts

TRADING ACTIVITY

Overnight Trading – Weak Data Triggers Bond Buying Triggers Curve Inversion Triggers More Bond Buying: The catalysts for the flight-to-quality overnight were a weak retail sales report from China, a slightly softer-than-expected industrial production report from the Eurozone, and Germany’s 2Q GDP report showing the most influential Eurozone economy contracted 0.1% QoQ.  This marks the fourth quarter since Germany’s double-dip recession in 2012 in which the key economy has contracted.  The weak data has pushed sovereign yields lower overnight with the German 10-year down 3.8 bps to -0.65%, the 10-year U.K. gilt down 4.8 bps to 0.44%, and the 10-year Treasury down 12 bps to 1.57%.  Fed Funds Futures contracts are now trading at 1.53% for July 2019, imply a 25% greater likelihood of a fourth 25 bps rate cut before year end.  Eurozone stocks are down 1.9% while Japan’s Nikkei is up 1.0% and China’s CSI 300 is up 0.5%.  U.S. stock futures have been pounded overnight, down almost 400 points (1.5%) in early activity.

Yesterday – Stocks Rallied on Tariff Delay, Despite Yields Jump That Nearly Inverted a Key Curve Measure: Risk appetite improved sharply just after the opening of the U.S. equity trading session, following news that the U.S. was softening its stance on September tariffs on China. The resurgence started with a statement from China’s Commerce Ministry indicating trade officials from the U.S. and China had spoken by phone and would hold another call in two weeks. Minutes later, the U.S. Trade Representative’s office released a statement announcing a more targeted approach to the 10% tariff set to begin in September. While some goods will still have a 10% tariff placed on them, “certain products are being removed from the tariff list based on health, safety, national security and other factors” and others will be delayed. Through a review process, “it was determined that the tariff should be delayed to December 15 for certain articles. Products in this group include, for example, cell phones, laptop computers, video game consoles, certain toys, computer monitors, and certain items of footwear and clothing.” President Trump later described the call with China as “very productive,” adding he believes Beijing wants to “do something dramatic” on trade. He also addressed the tariff changes, saying “We’ve delayed it so it won’t be relevant to the Christmas shopping season.” Tech company stocks surged on the news and retailers led gains in consumer discretionary stocks. With all 11 sectors stronger, the S&P 500 rose 1.5% and completely erased Monday’s fear-driven sell-off. Treasury yields, which were higher after another hot CPI report, responded to the trade headlines with a notable jump of their own. Despite the relief on trade, some anxiety remained as the jump in shorter yields outpaced the push farther out on the curve, pushing the slope between the 2- and 10-year notes to as low as 0.8 bps intraday. The 2-year yield rose 8.3 bps to 1.67% while the 10-year yield added 5.8 bps to 1.70%.