Yield Curve Inversion (2s/10s) Spooks Investors

Equity markets fall, equity markets rise... and round and round we go with trade headlines proving to stimulate and deflate markets with each passing week. On Tuesday, and following a greater than 1% decline in the major averages on Monday, a rally spurred by trade headlines ensued. But we'll get to that in a moment.

For the last few weeks, the S&P 500 (SPX) has been declining under the weight of several headwinds and fear-driven issues:

  • Trade war: This is likely the largest fear the market has driven into the psyche of investors/traders. The reason this holds the attention and emotion of many investors is because it has proven to reduce global economic activity. The Trade war issue remains one top and front of mind within investors surveyed by BofAML.

  • Everything thereafter the trade war issue seems to originate, as the global economy would prove rather healthy absent the aforementioned trade war that is now more than a year old.
  • The strong dollar has proven to weigh on domestic corporate earnings, but by and large, investors look past the forex issues in favor of organic results or ex-foreign exchange issues. Moreover, most corporations have done a reasonable job of hedging forex issues over the years, but it is a cumbersome process and an annoyance.
  • China's domestic economy slowing, even prior to the trade war.
  • Economic policy uncertainty that remains elevated under the current White House Administration. It's clear to see that when we look at the period before 2016-present, the index was more docile and remained at much lower levels. (5-yr. chart)

  • Hong Kong civil unrest.
  • Inverted U.S. Treasury bond yield curve. This last point of concern for market goers is a result of media hype, history and a function of how the credit markets work with respect to lending practices.

With respect to all the concerns noted above, the market has historically climbed these macro and micro-economic walls of worry. One of the reasons the S&P 500 and peer indices are able to perform this feat of strength is largely due to one unfailing principle of the markets: "Markets follow earnings over time." That's it; it is just that simple! While all the issues noted above are relevant and may weigh on the growth of the S&P 500 earnings, as long as those earnings are growing, the market will follow over time. But speaking to the last point of concern on our list above, how focused should we be on the flattening and eventual inversion of the bond yield curve, specifically the 2s/10s bond yields?

It's important, don't get us wrong. This part of the yield curve is where the shadow banking system picks up where the traditional lenders leave off. To that extent, the real problem isn't the yield curve inverting, it's how long it remains inverted. And to that point, both the 2-year and 10-year yield remain below the Fed Funds Rate (FFR). This forces the Fed to further reduce/ease rates going forward, in part.

Ahead of the market opening on Wednesday, equity futures are already in the red, as the spread between the 2s/10s is less than 1 bps. The curve has been flattening further and since the Fed eased rates in July, not something they likely anticipated as recessionary fears sparked by escalation of the trade feud carried forward. It's very, very likely that the yield curve will indeed invert soon enough. The yield curve has been covered in the press for over 2 years now. When the curve inverts, it is likely to trigger some degree of selling pressure. Algorithms and programmed trading are tuned to such circumstances and keywords generated in media headlines. What matters most is what one does should such selling take place in the equity market. In this case, history may prove a useful guide for investors and traders alike.

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