The Yield Curve Just Inverted... Doomsday?

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Yesterday, December 3, 2018, the United States Treasury Yield curve officially inverted for the first time since the Great Recession around the three- and five-year Treasury yields, with the yield closing at 2.840% and 2.830%, respectively. Of course, this resulted in headline readers reaching out to their brokers to liquidate their stocks in favor of cash and gold as doomsday approaches. As previously discussed in our blog posted earlier this year, the inversion of the US Treasury Yield curve can be an indication of a recession occurring in the near future, however, there needs to be a “perfect storm” of yield curve inversion in order to safely say a recession is oncoming.

(U.S. Treasury Yield Curve, data sourced from Capital IQ. Orange circle is indicative of yield curve inversion)

[Click to enlarge]

Not Doomsday (not yet at least)

This is where today’s inversion is not indicative of a full-on doomsday scenario as the three- and five-year yield inversion has historically been non-significant in a recession occurring within the near future. When looking to determine if a recession is on the horizon, further analysis of the two- and ten-year treasury yield spreads is necessary (10-2 Spread). An inversion occurs when the spread amongst two yields turns negative. The chart below shows the 10-2 spread from the beginning of this year through December 3, 2018.

[Click to enlarge]

The entire year of 2018 has had a downward trajectory in the 10-2-year spread, with an overall compression of 0.43% to a spread of 0.15% as of December 3, 2018. The closing spread yesterday represented the lowest 10-2 spread since the Great Recession. This is much more of a cause of concern than the inversion which occurred today, as the 10-2 spread turning negative is one of the few confirmed methods of predicting a recession.

Conflicts with recent Federal Reserve Comments

With the Federal Reserve’s most recent comments being interpreted to have a dovish stance, the 10-2 spread has moved even closer together, with a 0.06% decrease between November 30, 2018, and December 3, 2018. This could be due to investors looking to purchase longer-term bonds which have higher interest rates and therefore the increase in purchases is driving the yield down in comparison to the shorter term-bonds. However, the Federal Reserve has maintained a hawkish policy throughout 2018, and the 10-2 spread has maintained a downward trajectory. Regardless, this hint at a dovish stance is the first occurrence within 2018 which was followed by a decline in the 10-2 spread over a three-day period which has not been seen all year and needs to be mentioned.

USMCA May Have Larger Impact Than Thought

One of the reasons the Federal Reserves states they will raise interest rates is to “cool off” an economy which is deemed to be growing too quickly. With the signing of USMCA by the respective heads of each country and the final approvals being sent through the appropriate channels, the acceptance or rejection of the USMCA could be one of the many butterfly effect factors leading to the next recession. If the agreement is accepted, the economy may grow at a pace which would cause the Federal Reserve to raise short term interest rates, and if the past 12 months have been any indication of the next, the long-term interest rates will not raise in conjunction, thus causing a yield curve inversion. On the other hand, if the agreement is not accepted, the countries will revert to a pre-NAFTA world, which would cause an economic slow-down across North America, possibly sending the countries into technical recession (two consecutive quarters of negative GDP growth). Of course, all this is speculative, and I will readily admit that I have not read the entirety of USMCA.