Yield curve inversion hits mark not seen since dot-com bubble. Are Reagan-era levels next?

Melpomenem

Yield curve inversion reached its widest mark since the dot-com bubble early Friday, with a further steeping of this closely watched recession signal potentially conjuring ghosts of the stagflation days of the early 1980s.

During Friday's early action, the inversion between the 2-year and 10-year Treasury notes reached a new multi-decade low of -41 basis points. This occurred soon after the release of a jobs report that came in substantially stronger than economists had predicted.

While robust job growth might argue against the likelihood of a recession, traders interpreted the results as opening the door to a more hawkish Federal Reserve. Aggressive interest rate hikes from the Fed are considered a potential threat to the economy, as they could trigger a pronounced economic downturn.

The employment report prompted a spike in Treasury yields, leading to a peak inversion level of -41 basis points shortly after the data came out. The 2-year yield spiked to around 3.25% and the 10-year advanced to near 2.85%. (Note: these numbers include some rounding.)

Inversion refers to a situation where longer-term bond yields are lower than short-duration yields for similar debt instruments.

Under normal circumstances, longer-term yields tend to be higher than shorter-term ones, everything else being equal. These increased rates compensate lenders for tying up their funds for a longer period of time.

When inversion occurs, it suggests that bond buyers have a dimmer view of longer-term economic prospects. As such, the situation is viewed as a strong recession signal. Looking historically, the red flag proved correct during recent extended inversions in 2000 and 2006-2007.

After spiking immediately after the jobs report, yields moderated their move somewhat, with the inversion between the 2-year and 10-year notes contracting slightly. By late morning, the U.S. 10-year Treasury yield (US10Y) was up 15 basis points to 2.83%. At the same time the U.S. 2-year Treasury yield (US2Y) had climbed by 18 basis points to 3.21%.

The -41-basis-point level marked the largest inversion since 2000, in the midst of the popping of the dot-com bubble and anticipating the recession of 2001. The figure also came within sight of an April 2000 low of -52 basis points -- the widest inversion of the dot-com cycle.

If inversion pushes past the -52 mark, the next stop would be a low 40 years ago. In February of 1982, the inversion hit a point of more than -70 basis points. The widest inversion since 1976 (the furthest back the Fed offers data) came in March of 1980, when the measure reached an astounding -240 basis points -- a gap of more than two full percentage points.

Treasury ETFs in focus as curve inverts: (NYSEARCA:AGG), (NASDAQ:BND), (NASDAQ:TLT), (NASDAQ:IEI), (IEF), (SHY), (GOVT), (SHV), (BIL), (VGSH), (VGIT), (SCHO), (SCHR), (SPTL), (TLH), and (VGLT).

See a longer-term chart showing the history of the 2- and 10-year Treasury spread. Additionally, in broader market news all three major market averages have declined during Friday’s trading session.