The bond market flashed a warning on Friday, sending stocks plummeting as investors fretted that this was surely a sign of recession.
When the interest yield on the 10-year US Treasury bond becomes the same or lower as the two-year bond, recessions have often followed.
Ten-year Treasury yields, which were already at a one-year low, declined further on Friday. This time, they crossed below the yield of the three-month bond.
That "inversion" was the first since 2007, Bloomberg said. The spread between the yields suggests that bond investors are more worried about getting a return in the short-term than they are for the long term. That means they're betting on a decline in US growth.
The yield curve inverted between the two- and 10-year yield before the recessions of 1981, 1991, 2000, and 2008. An inversion on that part of the yield curve has preceded all nine US recessions since 1955. Clearly different sections of the yield curve have inverted at different times without recession following but major inversions are often a leading indicator of wider economic malaise or uncertainty.
The curve is the line that plots the difference between them over time. Right now that line is trending toward zero, or flat. If the line goes below zero an inversion in which the yield on the two-year bond would be greater than the 10-year that traditionally signals something is very wrong in the market.
Why? Because a flat or negative yield curve suggests investors believe keeping your money in short-term bonds is more uncertain than bonds that pay off a decade from now. Think about it. That position doesnt make sense. Why would you be more certain about 2028 than 2020? Thus, when the curve inverts, it signals something very risky is happening in the near-term asset markets.
Hey presto, recessions follow.
The curve reacts to a lot of things. For instance, it reacts to how investors feel about risk in other assets. If investors think the world is suddenly going to become very risky, very soon, they will pile into bonds they think are safe.
This has been evidenced by the mass sell off in equities last Friday and Monday with the US 10 year note trading up 0.4% as of 10.10 a.m in London (6.10 a.m ET).
Chinese debt. Trumps trade wars. Brexit. Italian debt. Global growth fears. Right now much of the economic and political world looks as if it is composed entirely of uncertainty. Its bad today. Surely well have fixed the world in 2028?
So the flat curve could be signalling a bit of that.
Investors will be closely watching the curve in coming days to assess the likelihood of an impending US recession.
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