Yield Curve Inversion Slams Stock ETFs

Financial markets were stunned today after two key interest rates crossed each other, raising worries about an economic downturn. The U.S. 10-year Treasury yield briefly fell below the U.S. two-year Treasury yield, an unusual phenomenon that is often said to be the harbinger of a recession.

This isn’t the first inversion scare of the year. An inversion (when longer-dated Treasuries yield less than shorter-dated Treasuries) of the 10-year and three-month Treasuries took place in March and then again in May. That part of the yield curve has been inverted for nearly four straight months.

According to the Federal Reserve, an inverted yield curve has preceded each of the past seven recessions. Moreover, the historical record shows that following an inversion, a recession tends to follow about a year or two later.

Equities Walloped

With the yield curve flashing red, it’s understandable why investors would run for the exits. As of this writing, the SPDR S&P 500 ETF Trust (SPY) was down 2.2% on the day, pressured not only by the yield curve inversion but weak economic data from Germany and China.

Germany’s economy contracted in the second quarter, while China’s industrial output grew at its slowest pace in 17 years. Both data points corroborated the yield curve warning and added fire to the view that the global economy is slowing sharply and may be headed for a downturn.

Sector ETFs tied to financials, energy, technology and industrials were among the worst performers on Wednesday, with losses of 2-3%. Less economically sensitive sectors like consumer staples and real estate fared better, shedding less than 1%. Utilities, another safe sector, was actually up by 0.5%.

Record Low Yields

While stocks were mostly hammered, safe-haven bonds continued to surge. The 30-year Treasury bond yield slipped as low as 2.01%, breaking under its previous all-time low of 2.09% in 2016. Meanwhile, the 10-year yield sunk below 1.59%, still above the record low of 1.32%.

ETFs tied to Treasuries, like the iShares 20+ Year Treasury Bond ETF (TLT) and the iShares 7-10 Year Treasury Bond ETF (IEF), surged 2.1% and 0.7%, respectively, to last trade at record or close-to-record highs.

At the same time, safe-haven gold leapt to a six-year high above $1,520/oz. The SPDR Gold Trust (GLD) was last trading up 1.1% on the day and 18% on a year-to-date basis.

What It Means For Investors

Today’s trading is shaping up to be a notable “risk off” day, triggered by another yield curve inversion. But investors should put the signal in perspective.

Even if a recession is on the horizon, there is no telling exactly when it will take place.

Recessions have occurred anywhere from half a year to 2 ½ years following an inversion. Perhaps more importantly for investors, stocks usually continue to rise after a yield curve inversion.

Over the past six recessions, “the average peak in the S&P 500 Index occurred 31 months after we hit the inversion trigger,” according to Wells Fargo Asset Management.

Predictive Power Waning?

Some even argue the yield curve has lost its predictive power, saying that yield curve inversions are bound to be more common when rates are at ultra-low levels.

In a paper from last year, the Richmond Fed said that “If the term premium stays persistently low or negative, then yield curve inversions are likely to become more frequent even if recessions have not become any more likely.”

There’s also the argument that a yield curve inversion with interest rates declining is far less ominous than when interest rates are rising, with the latter indicating the Fed has overtightened monetary policy.

With all that said, “it’s different this time” is a dangerous phrase to mutter in financial markets. Historically, the yield curve has been one of the most accurate predictors of economic downturns in the U.S. That doesn’t mean investors should panic, but it means investors shouldn’t be caught off guard if things do go sour.

​Email Sumit Roy at [email protected] or follow him on Twitter @sumitroy2