Good evening,
U.S. equity markets fell approximately 3% today, after the U.S. Treasury yield curve inverted for the first time since 2007. Widely considered a harbinger of recession, the inversion saw the yield on the 10-year U.S. Treasury slip below that of the 2-year U.S. Treasury. Under normal circumstances, yields on longer-dated bonds such as 10-year and 30-year maturities are higher than those on shorter-dated bonds, as investors generally demand a higher rate of return to lend their money for a longer period of time. However, as investors become concerned about future economic growth, they will often crowd into “safe-haven” assets such as longer-dated U.S. Treasuries, driving longer rates lower.
Today’s inversion represents the culmination of a number of factors, the most obvious being concerns about slowing global economic growth. More immediately, overnight, German economic data showed that the EU’s dominant economy shrank -0.1% in the second quarter, impacted not only by trade tensions but also ongoing uncertainties related to Brexit. At the same time, Chinese economic data showed that industrial output fell to a 17-year low, while retail sales growth fell well below consensus expectations. Additionally, U.S. corporate revenue and earnings reports, which first began to show weakness in 4Q18 due to slowing conditions in China, have shown further signs of strain as the year has progressed, exacerbated by ongoing trade tensions. Technology and Industrials have arguably been the two most impacted sectors to date.
These data points added to, and exacerbated, ongoing concerns about slowing economic growth, leading to increased demand for U.S. Treasuries at the start of today’s trading session. With the 2-10 spread having ended yesterday at under 0.02%, it took very little buying pressure today to tip the spread into negative territory.
Now that the inversion has occurred, the obvious question is “What happens next?” If history is any guide, most inversions are typically followed by a recession within 18-24 months. And while we are hesitant to utter the dreaded phrase, “This time it’s different”, there are several factors to consider.
First, inversions often occur following a Fed rate-tightening cycle. After tightening rates throughout 2017 and 2018, the U.S. Federal Reserve actually cut rates for the first time in a decade at its July meeting. Unlike other interest rate cycles, the Fed cut rates even as the U.S. economy appears to be doing relatively well, highlighted by unemployment which is currently near a 50-year low. This suggests that the Fed is willing to be more proactive in trying to prevent an economic downturn than in prior periods.
Second, the global economy and financial markets continue to become ever more interconnected. For much of the recovery, U.S. Treasury yields have had a hard time escaping the gravitational pull of European government bond yields, in particular Germany government bonds. With the entire German yield curve turning negative at the start of August, it is not surprising that U.S. yields have also moved lower.
Finally, while it would be overly simplistic to suggest that an end to the current U.S./China trade war would automatically result in a reacceleration in global growth, without question it would help. To that end, should Chinese and U.S. political leaders quickly decide to set aside their differences and strike a deal, at a minimum, it would improve corporate earnings both in the U.S. and abroad. Such would likely stabilize equity markets and provide support for a normalized yield curve.
To the casual observer, today’s inversion may appear to have been unexpected, especially given the deluge of panicked headlines it produced. As regular readers of our commentary know, however, this event evolved over many months. In fact, the shape of the yield curve has been one of the key risks we have discussed with clients for well over the past year. And, further, has been a consistent area of concern factored into our investment decisions. As such, the changes today are not a surprise and we feel we are largely positioned to manage the current volatility. To that end, today’s news out of Germany and China validates our recent decision to reduce our international allocations in favor of domestic holdings.
Despite today’s selloff and gloomy headlines, it is worth noting that the S&P 500 is up 13% for the year, well ahead of nearly all start-of-the-year forecasts. However, today’s inversion reinforces the need to remain vigilant for further signs of economic slowing. As always, we will continue to monitor market developments and take action as necessary. Should you have any questions, please do not hesitate to contact your First Western representative or me.
Sincerely,
John Sawyer, CFA
Chief Investment Officer
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