With constant whipsawing and mixed messages from the White House and the Fed alike, investors are seeking direction from the bond market that has traditionally provided the most reliable signals. While other sections of the U.S. Treasury yield curve have inverted for months as investors bet that U.S. and global growth would slow, yields on U.S. 10-year Treasury notes slid below those on two-year notes on Wednesday, delivering the first reliable recession signal.
Why is the treasury yield curve a bellweather to predict recessions? Typically, bond investors expect to be compensated more for taking on the added risk of owning bonds with longer maturities and so yield on the 10 year treasury is higher than those on the two year note. When shorter-dated yields are higher than longer-dated ones and is called an inversion, that means there is an expectation of weaker growth in the future.
When inversion happens, a series of events follow – consumer borrowing costs rise and consumer spending, which accounts for more than two-thirds of U.S. economic activity, slows. The economy eventually contracts and unemployment rises. The trick for investors is figuring out how long it takes from yield inversion to recession.
Future Wealth’s View
There is no denying that the yield curve inversion is a classic signal of a looming recession. The U.S. curve has inverted before each recession in the past 50 years. The problem with the current market conditions is that the large institutional investors are holding onto straws and trading on every tweet, every Fed move and eventually will run out of reasons and begin dumping their positions. It will take a few weeks before the average retail investor realizes that his or her positions are no longer going up and instead are headed down for a long time.
Next week, the world’s economist elites gather at Jackson Hole and it is widely expected that the consensus will be that Fed Chair – Powell will cut interest rates again next month as insurance against a global slowdown. While most believe that they don’t see any imminent risk of recession, partly because consumers make up 70% of the U.S. economy and have continued to spend, we believe most economists are underestimating the impact of the trade war and how quickly the average consumer will stop spending from the increasing cost of products resulting from the tariffs.
Then there is the problem with Fed’s basic premise – they look at past data and many times it is too late to make the right moves to correct or change course. As the saying goes “You can observe a lot by just watching” and then conclude that the Fed made “made too many wrong mistakes” or make the right moves without waiting for the next recession to burn your portfolio down.