The latest inversion of a popular Treasury yield spread has intensified an already heightened state of nervousness among investors. Equities have increasingly come under pressure as news headlines generate ever more fear, creating a negative feedback loop in which fear begets more selling. In today's report we'll examine the latest fears over the yield curve inversion. I'll make the case here that investors are focusing on the wrong yield curve and that the market's recent decline should be reversed once sanity has been restored by later this month.
As if there weren't enough near-term headwinds facing the equity market, a growing list of concerns, ranging from trade tariffs to interest rates, have sent participants into panic mode. Stock prices with exposure to China in particular have been hammered mercilessly in recent days as investors head for the exits and rush into safe haven assets.
Fueling the growing fears of retail investors, Morgan Stanley suggested in a research note that an escalation of the U.S.-China trade war could cause a global recession "in three quarters." The investment bank's chief economist, Chetan Ahya, wrote:
Investors are generally of the view that the trade dispute could drag on for longer, but they appear to be overlooking its potential impact on the global macro outlook."
President Trump has also threatened to place a 5% tariff on all imports from Mexico starting June 10. And while the fear of a global recession has been in the back of investors' collective mind for some time now, it's suddenly becoming a more palpable concern due to the latest tariff threats. This concern is nowhere more evident than in the widely-watched spread between 10-year and 3-month U.S. Treasury yields. This popular yield curve has "inverted," as you can see in the following graph. This means that yields on 3-month Treasury bills have exceeded the yields on the 10-year Treasury bond. An inverted yield curve has been used to predict recessions in the past, especially when the inversion lasts for several weeks.
Source: St. Louis Fred
By no means, however, can the inversion of the 10-year-3-month yield curve be used to predict imminent recession. Research has shown that when the Treasury yield curve inverts for an extended period (i.e. several weeks), an economic recession doesn't normally begin until at least six months have elapsed after the inversion first takes place - and sometimes as long as 18 months after the inversion. The yield curve, in other words, shouldn't be used to make short-to-intermediate-term investment decisions.
Another point worth considering is that while the 10-year minus 3-month Treasury yield spread has gone negative, other yield curves haven't yet inverted. For instance, the 10-year minus 2-year Treasury yield curve is still positively sloped as of June 3. Goldman Sachs pointed out a couple of months ago that this particular yield curve is more reliable for predicting recessions, and until it inverts investors should avoid assuming a worst-case view of the U.S. economy. The spread between the 10-year and 2-year note is normally where the market discounts the Federal Reserve's expected interest rate policy. Goldman analysts also noted that significant market declines typically begin once the yield curve has steepened after being inverted for a while. Recession, in other words, is still an improbability based on the message of the 10-year-2-year yield spread.
Source: St. Louis Fred
Concerning the widely cited inversion of the 10-year-3-month yield curve, it should also be noted that after inverting in July 2006, the stock market continued to climb until October 2007 before a bear market and economic recession finally occurred. In light of this consideration, investors are almost certainly overreacting to the latest news headlines rather than taking account of the many positive fundamental factors underlying the economy and stock market today.
I would also point out that corporate bond spreads aren't currently showing any concern among serious investors that credit conditions are tight, or that a recession is imminent. Shown here is a chart of 2-year swap spreads which was highlighted in the latest blog by Scott Grannis. The fact that swap spreads for both the U.S. and the euro zone are declining indicates that liquidity is still plentiful and that credit conditions aren't deteriorating. If recession was a legitimate threat, we would see swap spreads rising as they have done prior to the last couple of recessions.
Source: Calafia Beach Pundit
I've made the point in the last couple of panic attacks in the stock market that when the reason behind the market's decline is easy to identify, the decline is usually reversed quickly once the fears driving the selling pressure have diminished. In the present case, the catalyst behind Wall Street's latest selling panic is easy to see, namely the fear of a global recession due to the threat of a tariff war. The inversion of the 10-month minus 3-month yield curve is also a catalyst behind the latest selling wave. And yet, with the Conference Board's Leading Economic Index increasing in the last three consecutive months, there are no signs of imminent trouble for the U.S. economy.
This further suggests that investors' fears of recession are misplaced and that once the panic generated by threatened higher tariffs on Mexican and Chinese imports has faded, investors will quickly reassess the economic situation and realize that the selling panic was carried too far. My expectation is for stock prices to hit bottom sometime this month and then go on to regain the losses since May this summer.
One sign that a short-term market bottom is getting close is the latest position of the 20-day price oscillator for the S&P 500 Index (SPX). This is my favorite measure of how "overbought" or "oversold" the broad market is on a short-term basis. As you can see here, the 20-day oscillator is very close to the extreme oversold levels which have coincided with past market lows, including the major bottom last December. The SPX oscillator also suggests that the market is becoming quite vulnerable to a short-covering rally given the extent to which short interest has increased lately.
Another sign suggesting that Wall Street's latest panic attack will soon end can be seen in the extent to which investor sentiment has become bearish in just the last few days. The CNN Business Fear & Greed Index has fallen deeply into "fear" territory, as the graph below illustrates. On June 3, the index registered a reading of 23 (out of a possible 100), indicating that there's more fear in the stock market than greed. Such low levels are normally indicative of a market which is near a completely sold out condition in the immediate term.
Source: CNN Business
While the market is clearly getting close to an important juncture based on the extremity of its "oversold" condition, one major factor needs to be seen before we get a confirmed bottom. Specifically, we must see a reduction in the number of NYSE and Nasdaq-listed stocks making new 52-week lows. This I consider to be the most critical factor for evaluating the market's near-term health. In the last few weeks, the new 52-week lows on both exchanges have been well above 40 and even in the triple digits. This suggests above-normal selling pressure, and until this pressure diminishes there will always be a threat of lower stock prices - even given how "oversold" the market is right now.
To that end, we should see a reversal in the 4-week rate of change (momentum) in the new 52-week highs and lows. Below is my favorite indicator for showing the near-term path of least resistance for stocks. It's the 4-week momentum indicator for the NYSE new highs and lows. As long as this indicator is declining, the danger that stock prices will decline further is still there. Investors should therefore avoid making new commitments in individual stocks until the new 52-week lows dry up and this indicator reverses its declining trend.
It's clear that investors are being unduly influenced by news headlines which pertain to the global trade outlook. Fear is an ephemeral emotion, however, and investors should expect to see the recent fear wave dissipating soon. When it does, and when there has been a corresponding decline in stocks making new lows, there will be an excellent buying opportunity which I anticipate will occur by later this month. For now, though, a defensive stance is still justified as the sellers still have control over the stock market's immediate-term (1-4 week) trend.
On a strategic note, my trading position in my favorite market-tracking ETF, the Invesco S&P 500 Quality ETF (SPHQ), was stopped out on May 10 after the ETF fell under the $31.70 level on an intraday basis, triggering my stop loss. This put me back in a cash position in my short-term trading portfolio. Meanwhile, investors can maintain longer-term positions in fundamentally sound stocks in the top-performing real estate and utilities sectors as we wait for the latest short-term market weakness to dissipate.
Disclosure: I am/we are long GDX. 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.