Last Monday the 10-Year Treasury Note yield declined nine basis points to end at 1.65% and the S&P 500 headed lower. Then on Wednesday when the 10-Year yield started the day down another 10 basis points and below the 2-Year Treasury Note yield, alarm bells began ringing as the yield curve briefly inverted. The Market Review explains why the markets have become so sensitive to inverted yield curves along with some thoughts on what's next.

S&P 500 Index (SPX)2888.68 dropped 29.97 points or -1.03% last week including a 2.93% decline Wednesday after the widely followed 10-2 Treasury Note yield curve briefly inverted before recovering to end the day positive by one basis point. The SPX chart below includes the 10-2 Treasury yield spread at the bottom.

The 10-2 spread closed positive on Wednesday, but SPX closed 85.72 points lower.

By Friday the spread was back to positive .07, down 4 basis points for the week.

"Every U.S recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve."

" An extensive analysis of various models leads us to conclude that the term spread is by far the most reliable predictor of recessions, and its predictive power is largely unaffected by including additional variables."

In an obvious attempt to save the Fed's reputation and calm the markets, former Federal Reserve Chair, Janet Yellen said on TV Friday, that due to unusual circumstances, "this time it's different, " but markets are skeptical, since, from experience, professionals know not to rely on "this time it's different" comments, especially when the research indicates otherwise. Here's the research: FRBSF Economic Letter, Information in the Yield curve about Future Recessions.

"There is no clear evidence in the data that 'this time is different' or that forecasters should ignore part of the current yield curve flattening because of the presumed macro-financial effects of QE."

In addition, they add, "...indicating an inversion of the yield curve, about a year or two before the onset of a recession."

In February Deutsche Bank released research showing the average lead time for the last nine recessions since 1956, from inversion to recession at 21 months, including the last episode when the inversion began December 27, 2005, followed by a recession 24 months later on January 1, 2008.

Jolted by the quick drop in interest rates, FOMC traders were likely so busy on Wednesday they missed lunch, doing all they could to keep the 10-2 spread from closing the day with an inversion.

While Wednesday's SPX decline was not hysteria as some claim, it's certainly an indication of how sensitive the markets have become to a Treasury yield inversion in a highly leveraged global environment.

Referring to the SPX chart above, there is a potential bullish small double bottom pattern intersected by the operative upward sloping trendline, USTL. To activate, SPX would first need to overcome resistance from the USTL and then the 50-day Moving Average currently at 2944.78. While certainly not impossible, it seems unlikely without an announcement of a breakthrough in the trade negotiations with China.

CBOE Volatility Index® (VIX) 18.47 advanced .50 points or +2.78% last week. Our similar IVolatility Implied Volatility Index Mean, IVXM using four at-the-money options for each expiration period along with our proprietary technique that includes the delta and vega of each option, gained .85 points or +5.51%, ending at 16.28. The one-year charts below show the IVXM in a range between 15% and 20%.

VIX Futures Premium

The chart below shows as our calculation of Larry McMillan’s day-weighted average between the first and second-month futures contracts.     

With just two trading days until August expiration, the day-weighted premium between August and September allocated 8% to August and 92% to September for a premium of 4.76%, in the yellow caution zone, compared to 3.12%, for the week ending August 9.

The premium measures the amount that futures currently trade above or below the cash VIX, (contango or backwardation) until front month futures contract converges with the VIX at expiration on Wednesday.

For daily updates, follow our end-of-day volume weighted premium version located about halfway down the home page in the Options Data Analysis section on our website.

Strategy

Caution and hedging long risk remain the modus operandi as long the S&P 500 Index remains below the operative upward sloping trendline shown in the chart above.

Despite retail sales increasing 0.7 percent in July, declining interest rates suggest weaker economic conditions. However, until the 10-2 Treasury yield spread stays inverted for a lengthy period, calls for a recession anytime soon seem premature, since the Federal Reserve can lower short-term interest rates to change the slope of the yield curve.

Summary

In a surprising display of sensitivity to the slope of the Treasury yield curve, the S&P Index declined 2.93% last Wednesday when the spread between the 10-Year and 2-Year Treasury Note briefly turned negative. Although research shows the lead-time from inversion to recession is 21 months on average, markets are expressing displeasure with the current interest rate situation. While China trade news remained in focus as the number two concern, last week was mostly an interest rate story.