Is An Inverted Yield A Harbinger Of Bad News?

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by: Shock Exchange
Summary

The Treasury yield curve inverted for the first time since the last recession.

An inverted yield curve likely portends a recession is on the horizon.

Falling RV shipments could also predict recession.

There could be pain ahead for stocks and cyclical names, in particular.

Fed Chairman Jerome Powell. Source: Wealth 365

Fed Chairman Jerome Powell. Wealth 365

The February unemployment rate was 3.8 percent, well below the 5.0 percent threshold considered full-employment. Wage growth was also solid, implying the economy remains strong. However, the yield curve suggests future economic growth could be lacking. The spread between the 3-month and 10-year Treasury yields recently inverted for the first time since the last financial crisis:

The Treasury yield curve inverted for the first time since the last crisis Friday, triggering the first reliable market signal of an impending recession and rate-cutting cycle.

The gap between the three-month and 10-year yields vanished as a surge of buying pushed the latter to a 14-month low of 2.416 percent. Inversion is considered a reliable harbinger of recession in the U.S., within roughly the next 18 months.

Some argue the inverted yield curve is not predicting anything; yields could be distorted due to trillions in bond-buying by the Federal Reserve over the past decade. At the end of the day, one of the longest economic expansions on record could eventually come to an end.

Federal Reserve Chairman Jerome Powell had been hiking short-term rates to beat back inflation; a measure of inflation could be wage growth or growth in personal consumption expenditures ("PCE") at or above the Fed's 2 percent target. I suspected the Fed was also attempting to burst bubbles in stocks and real estate. The fact that investors are willing to bid up prices for 10-year Treasuries and drive the yield to a 14-month low suggest they do not expect rising prices to eat into their fixed income stream. This could be bearish signal for future economic growth.

Why The Yield Curve Is Important

The following chart illustrates 10-year Treasury yields minus 3-month Treasury yields historically.

Yield Curve The shaded areas of the chart reflect when the U.S. economy went into recession. Prior to the last three recessions, the yields on long-term bonds minus the yields on short-term bonds were negative or "inverted."

Several economists failed to warn on the Financial Crisis of 2008. They are actively looking for signs of a slowing economy; an inverted yield curve has proven pretty accurate. It could force politicians and the Fed to change their tone on how strong the economy is truly is.

Other Signs Of A Faltering Economy

There are other signs the U.S. economy is not on solid footing. Despite the low unemployment rate, the number of working age people not in the labor force exceeds 95 million. This is much higher than the approximately 80 million people no longer in the labor force in February 2009, just after the Financial Crisis began; it could be considered a national crisis.

A decline in RV shipments could also be harbinger of bad news. A decline in annual RV shipments has preceded the prior two recessions. 2018 RV shipments declined 4 percent Y/Y. Through year-to-date February 2019, shipments were about 62,000, down 28% Y/Y. Consumers could cut these discretionary items first when they are less optimistic about the future. Declines in discretionary spending could metastasize to other sectors like autos or luxury goods. Such an event would not bode well for long-term economic growth.

Conclusion

An inverted yield curve is usually a harbinger of recession. A decline in RV shipments appears to support that thesis. There could pain ahead for broader markets and cyclical names, in particular.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.