Brexit Fallout

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Last month's Brexit vote really did a number on U.S. markets - equity and fixed income alike. The immediate aftermath, however, has been vastly disparate.

Just ahead of the final vote tally, the S&P 500 (NYSEARCA:SPY) rose above 18,000 on traders' confidence of a "Remain" victory. The next day, after a surprise win by the "Leave" side, the blue chip index plunged more than 600 points. By the time the dust cleared the following market day, U.S. stocks had plummeted nearly 5 percent. Not the end of the world, but painful nonetheless.

The pain subsided by the time the closing bell rang on the first day of July, just a week after the vote. By then, the S&P had recovered most all of its loss. In fact, if you discount the pre-vote euphoria, the domestic stock market is actually ahead. For stock investors, at least those in the domestic market, Brexit is a non-event.

And bonds? Well, bonds have gone nuts. And no wonder. U.S. Treasurys, like gold, were the go-to investments during the hair-on-fire reaction to the Brexit vote. Thirty-year T-bond yields ratcheted down more than 30 basis points. Ten-year note rates dropped nearly as much. But here's the thing: yields aren't bouncing back. Brexit clearly isn't a non-event for fixed-income investors.

And if you look at the Treasury yield curve, you might be inclined to think that rates will continue their southward migration.

The spread between short and long rates has been getting squeezed for the past three years, mostly because of safe-haven buying of longer-term paper. In the wake of the Brexit vote, the yield differential between 3-month T-bills and 30-year T-bonds slipped below 2 percent, nearly a full percentage point below its year-ago level. Given the technical picture (see the chart below), you could make a case for further curve flattening, perhaps by another 100 basis points or so.

Severe flattening or worse, inversion, of the yield curve is an oft-touted warning sign of recession. But recessionistas shouldn't get cocky just yet. Over the past 25 years, the curve's averaged 244 basis points at this time of year and has dipped below 200 basis points nine times. On five occasions, the spread got below 100 basis points. Just twice - in 2000 and again in 2007 - did that foretell a recession in the following year. In July 2000, the yield curve actually inverted to -0.13 percent; by March 2001, the U.S. slipped into a nine-month recession. An 18-month economic slump was heralded by a 0.14 percent spread in July 2007.

So, it's possible that the U.S. economy could avoid recession even as yields at the long end get beat up. That means there's still some upside in the bond trade. For ETF investors, there's the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT), now trading at the $140-142 level. There's a short-term technical target (see below) at $145, which, if worked through, could put the $148 level in sight.