The bond market appears to be issuing a clear warning to the broader market, but some economists say that not all fixed-income alarm bells are created equal.
The 10-year Treasury note yield fell below its 3-month counterpart, deepening an inversion of the yield curve, which measures the difference between the yield on the longer-dated Treasury and its shorter-dated counterpart.
Such rate inversions are rare because investors tend to demand higher yields for extending loans over a longer period. Therefore when rates invert it is viewed as a signal that an economic recession is in the offing. The 10-year yield Treasury note TMUBMUSD10Y, -1.57% yields 2.22% while the three-month rate TMUBMUSD03M, -0.35% stands at 2.361% as of Wednesday midday trade, reflecting the most severe inversion between the pair since 2007, according to FactSet data.
Although Wall Street prefers to watch the 10-year and 2-year Treasury note TMUBMUSD02Y, -2.35% an inversion of the 10-year/3-month measure of the yield curve is widely viewed as a more reliable recession predictor. Inversions of the 10-year/3-month curve have preceded the past seven recessions, while throwing out two false positives with an inversion in late 1966 and a very flat curve in late 1998, according to the Federal Reserve Bank of Cleveland.
Thomas Lee, head of Fundstrat Global Advisors, says not all inversions are created equal and compared the current inversion with the situation seen in 1998. He said that when the yield curve inverts because demand for the 10-year Treasury is driving rates lower (see chart attached), it tends to reflect growing worries about risk rather than presaging a slowdown in the business cycle.
Back in 1998, the bond market saw an inversion due to the Russian debt crisis, which also led to the collapse of hedge-fund Long-Term Capital Management. But the Fundstrat analysts said that that period represented a major buying opportunity.
Lee put it this way in a Wednesday research note:
BOTTOM LINE: We think investors are “overreacting” to this inversion. In 1998, it was a huge tactical buy signal, as it marked “peak risk off”-that inversion was seen ~1.5% before equity markets bottomed and then embarked on a 48% rise over the next 10 months. Hmmm. as much as chop makes sense for markets right now, this inversion is being view too negatively.
Presently, investors were piling into government paper amid intensifying worries about a tariff tiff between the U.S. and China, which has caused the Dow Jones Industrial Average DJIA, +0.17% the S&P 500 index SPX, +0.21% and the Nasdaq Composite Index COMP, +0.27% to plumb their lowest levels in recent months.
The latest development in Sino-American trade tensions indicates that Beijing could curb its exports of rare earths to the U.S. as a retaliatory measure against Washington. A Chinese official from the National Development and Reform Commission said “if anyone wants to use imported rare earths against China, the Chinese people won’t agree,” according to Xinhua.