On March 22, 2019, the yield on the three-month U.S. Treasury eclipsed the yield on the 10-year U.S. Treasury. This garnered widespread attention among economists and market watchers because a yield curve inversion between the three-month and 10-year U.S. Treasuries has historically been a reliable predictor of recession. This is the first time since 2007 that this portion of the yield curve has inverted.
Flight to the safety of long-term treasuries not only drove the yield of the 10-year sharply lower, it contributed to the S&P 500’s worst day in months as it posted 1.89 percent losses.
While this disappearance of the yield gap between long- and short-term Treasuries has preceded the past seven recessions, it has historically taken six months to two years after the inversion for an economic slump to follow.
“Inversions typically reduce the profitability of the ‘carry trade,’ a key revenue instrument for banks and other lending institutions whereby lenders borrow short and lend long,” explained James Camp, CFA, Managing Director of Fixed Income and Strategic Income at Eagle Asset Management, an affiliate of Carillon Tower Advisers. “Historically, inversions have resulted in a reduction in lending, leading to slower or negative economic growth.”
Market watchers may recall numerous inversions across the yield curve since late last year. Economists at the time were quick to note that it is the three-month and 10-year Treasury spread, the Fed’s preferred yield curve measure, which is a more accurate bellwether for recession.
“Economic indicators that we follow have deteriorated in recent months,” said Camp. “Most recently the German Bund yield has dipped below zero.”
This data, coupled with the Fed’s dovish stance on interest rates earlier in the week, support a view that a global economic slowdown may be in progress.
“Today’s yield curve inversion suggests the Fed overshot on tightening despite the pivot away from the hawkishness of the previous quarter,” said Camp. “It’s important to note that the repercussions of an inverted yield curve are not immediate. But now the risks have increased and investors should be mindful about what they own and what this means for potential risk-adjusted returns in passive strategies going forward.”
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