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Bond markets flash major recession warning as Treasury yield curve inverts

Inversion of the yield curve for Treasury notes has preceded every recession over the past 50 years.
Image: U.S. Markets Open One Day After Dramatic Losses
Traders and financial professionals work at the opening bell on the floor of the New York Stock Exchange (NYSE) on Aug. 6, 2019.Drew Angerer / Getty Images
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The yield on the benchmark 10-year Treasury note on Wednesday broke below the 2-year rate, an odd bond market phenomenon that has been a reliable indicator for economic recessions. The move shows increasing worries about the global economy as investors rush into safe haven assets.

Early Wednesday, the yield on the benchmark 10-year Treasury note was at 1.623 percent, below that on the 2-year yield at 1.634 percent. The last inversion of this part of the yield curve was in December 2005, two years before a recession brought on by the financial crisis hit.

Investors are now demanding higher interest rates on short-term debt than they are longer term debt, a phenomena known as an “inverted yield curve.” Investors often give the spread between the 10-year and the 2-year special attention because inversions of that part of the curve have preceded every recession over the past 50 years, albeit even years before an economic downturn hit.

While the inversion is cause for concern, there is often a significant lag before a recession hits and an economic downturn ensues.

Data from Credit Suisse going back to 1978 shows:

  • The last five 2-10 inversions have eventually led to recessions.
  • A recession occurs, on average, 22 months following a 2-10 inversion.
  • The S&P 500 is up, on average, 12 percent one year after a 2-10 inversion.
  • It’s not until about 18 months after when the stock market usually turns and posts negative returns.

Going farther back in history, the yield curve’s track record gets a little more spotty. Post WWII, inversions have predicted seven of the last nine recessions, according to Sung Won Sohn, professor of economics at Loyola Marymount University and president of SS Economics.

“If the inversion started today, the economy could be in a recession within a year,” said Sohn.

Long-term yields have plummeted in August as concerns surrounding trade developments and GDP growth — coupled with expectations for lackluster inflation and more aggressive central bank action — have sent nervous traders in search of safer investments.

Central banks around the world, including the Federal Reserve, have pivoted once again to easing policies. Major government debt in countries like Germany now have negative yields.

The yield on the 10-year Treasury note, an important rate banks use when setting mortgage rates and other lending, has fallen a steep 40 basis points this month.

“The U.S. equity market is on borrowed time after the yield curve inverts. However, after an initial post-inversion dip, the S&P 500 can rally meaningfully prior to a bigger recession-related drawdown,” wrote Bank of America technical strategist Stephen Suttmeier.

A portion of the yield curve inverted earlier this year, raising economic concerns as the three-month yield topped the 10-year yield.

The popularity of the safety offered by bonds is at financial crisis levels among professional investors as many steel themselves for slowing growth ahead, according to a survey of fund managers conducted by Bank of America Merrill Lynch.

“While yield curve inversions can be a leading indicator of economic weakness or recession, they are an early warning sign,” Suttmeier added.