Bond market flashes yield curve warning

Jeannie Matthews
December 8, 2018

On Monday, the yield on the five-year Treasury note slipped below yields on shorter-dated three-year notes, according to a report in Bloomberg.

Whatever the reason, investors and economists ignore this message from the bond market at their peril: yield curve inversions - when shorter-dated securities yield more than longer maturities - have preceded every USA recession in recent memory by anywhere from 15 months to around two years. The yield on a short-term Treasury bond is now more valuable than the return on a longer-term bond. A recession isn't destiny, in other words: The Fed could respond to the yield curve's signal by cutting rates to head off the recession. Ahead of the 2001 recession, the entire curve dropped into inversion in sync in February 2000.

The 3-month to 10-year spread is now 0.492 percentage points.

The greenback has enjoyed months of unrivaled performance against its peers but that could be undermined by growing concern about slowing US growth.

What is a yield curve?

This happens when short-term rates rise above longer rates.

The Federal Reserve is widely expected to raise rates at its meeting on December 18-19. "We are following a strategy and taking account of data over time as it comes in and in response to significant changes in direction".

The moves follow similar declines in USA bank shares, which dropped 4.4 per cent on Tuesday.

Instead of just reflecting investors losing faith, Fed officials have argued that the recently narrowing gap between short- and long-term Treasury bonds could reflect long-term shifts in global capital flows, or the fact that all interest rates are lower and more compressed together than they used to be.

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Though it is not certain the narrowing in spreads is related to doubts about economic growth, alternate explanations would not necessarily be helpful to the Fed either.

The closely followed spread between the 2-year Treasury note yield and the 10-year Treasury note yield remains positive.

An inversion between 3-month Treasury bills and 10-year Treasury notes is viewed as a "more appropriate indicator" of a recession.

MSCI's gauge of stocks across the globe shed 2.16 percent, its worst performance since October 11.

"A lot of it is momentum", said John Canavan, market strategist with Stone & McCarthy Research Associates in NY.

The yield curve has flattened as continuing interest rate hikes send short-dated yields higher, while longer-dated Treasuries are supported by tepid inflation and slowing global growth.

Oil prices pared some gains as fears flared that demand would stall due to a trade war between the US and China, and that Russian Federation remained a stumbling block to a deal to cut global crude supply.

Last year's massive federal tax cut has bolstered business confidence, but trade tension between Washington and major USA trade partners looms as a possible economic drag, analysts said.

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