There’s been much ado about the stock market’s malaise lately, but bond investors have long been sending cautionary signals of their own.
A few months ago, investors became fixated on the yield curve. Specifically, the gap between yields on 2- and 10-year Treasury notes almost turned negative. The implication of a shrinking spread is that investors are demanding a higher premium for buying short-term bonds instead of long-term ones, which indicates their worry about the prospects for economic growth.
When the gap does fall below zero, it’s known as an inverted yield curve and has preceded every recession since at least 1975.
The inverted yield curve is back in play once again. As of Friday, the 2s-10s spread stood at 20 basis points, or 0.20%. In August, it fell to 19.1, the lowest since mid-2007.
The curve has flattened this year and short-term yields have jumped as the Treasury ramped up its selling of short-term debt to fund a growing budget shortfall. The department projects it will issue more than $1.3 trillion in debt this year, a 146% jump from last year and the highest issuance since 2010.
The curve has also flattened amid the Federal Reserve’s interest-rate hikes that have lifted shorter-dated yields.
All these drivers, coupled with the relatively sanguine nature of other parts of the economy, have led some commentators to say the yield curve is not flashing its traditional recession signal this time.
But others disagree, pointing to indicators in the stock market and other corners of fixed income as proof that investors are, at the very least, worried about a slowdown in growth.
David Rosenberg, the chief economist at Gluskin Sheff, has his eyes on another yield curve: the spread between 2- and 5-year notes.
“As an aside, the yield curve does not have to invert — the flattening trend on its own is also flashing a notable cooling off in growth in 2019, and a commensurate downward trajectory in EPS estimates,” Rosenberg said in recent a client note.
In other words, the stock market is sending a similar message to bonds.
He pointed out that, since the slump in the S&P 500 started in late September, the best-performing sectors have included consumer staples, utilities, and health care. That’s significant because they’re all associated with defensive posturing. Meanwhile, the underperformers include technology, consumer discretionary, and energy stocks.
“This sector shift towards defensives and away from cyclicals is a clear sign that Mr. Market is bracing for a discernible slowing in growth, or perhaps something even deeper than that,” Rosenberg said.
‘Mr. Market’ also had an instructive reaction to Fed Chairman Jerome Powell on Wednesday, when he said interest rates were just below the estimated neutral range that neither speeds up nor slows down the economy. Stocks surged, recording their strongest rally in eight months, on relief that borrowing costs in 2019 may not tighten monetary conditions as quickly as feared.
The market’s response was “symptomatic of despair,” Rosenberg said.
It’s worth considering that if the Fed is truly close to a level of interest rates that no longer propels the economy, Powell’s speech signaled the expectation for slower growth. This is a cue that the bond market, unlike stocks, seemed to take in stride.
“While the Dow and S&P 500 did indeed enjoy their second best session of the year, if the Fed truly has turned to a more dovish stance, wouldn’t that be reflected in the one security that is the most sensitive to shifts in monetary policy?” Rosenberg said. “I’m talking about the 2-year T-note yield, of course, which fell the grand total of 2 basis points yesterday [Wednesday] to 2.8%. Big deal.”