I’ve been telling readers of the GuerillaStockTrading blog and listeners of the weekly Saturday Stock Market Prediction Show to not worry about a Bear market until the yield curve inverts.

I’ve been using the yield curve as a tool for trading for many years. In 2013, I published this video that went viral on YouTube with more than 70,000 views called Quantitative Easing, Inflation, and the Yield Curve.

It happened today.

The U.S. Treasury yield curve just inverted for the first time in over a decade.

The bond market is starting to sound the alarm of a recession, with an inversion of U.S. Treasury yields occurring on Monday for the first time since 2007.

Inverted yield curve

No one should panic right now. Only a small part of the yield curve is inverted and it usually takes many months and perhaps a year, for the economy to go into a recession once the yield curve inverts. The big takeaway here is that what is happening in markets is not the run-of-the-mill buy-the-dip strategy that has worked so well for the last 9 years. You can’t expect to use the same trading strategy that you used 3 months ago, 6 months ago, a year ago, and expect it to still result in profitable trades.

The spread between three- and five-year Treasury yields dropped below zero, indicating the first section of the curve to invert in this cycle.

The return on the 5-year Treasury note fell below the yield on the 3-year note. The yield on a 5-year Treasury bond should be higher than the yield on a 3-year bond. This is happening because investors are betting on the Fed lowering interest rates in the near future. With lower prices around the corner, investors want to lock in the higher prices now for as long as they can and so they’re buying up 5-year Treasury bonds, which in turn has pushed down the 5-year yield below the 3-year yield. Why do investors think the Fed will soon be lowering interesting rates? Because a recession is coming.

The spread between short- and long-term Treasury yields has dropped below zero ahead of all the past seven recessions.

The inversion of 3- and 5-year yields suggests that we could get an inversion of the 2-year and 10-year yield in late 2018 or early 2019.

Again, no one should panic sell right now. It’s important to keep in mind the timeline between inversion and economic slowdowns, it’s not instantaneous. In response to a portion of the yield curve inverting, the Federal Reserve will probably leave interest rates flat, or could even cut in late 2019 or 2020. I’d argue that’s not just possible, but probable, given that we’re currently in one of the longest economic expansions in U.S. history.

Shorter-dated yields climbed faster than longer-dated yields, pushing the curve to invert between the 3- and 5-year yield. Why did this region of the yield curve invert first rather than the spread between seven- and 10-year Treasuries? One reason could be that the Fed’s balance-sheet reduction is putting greater pressure on 10-year notes than shorter-dated maturities, which wasn’t true during past periods of inversion.

The yield curve inverted between both 7-year and 10-year yields before the recessions of 1981, 1991, 2000 and 2008. It’s preceded all nine U.S. recessions since 1955, with a lag time of recession ranging from six months to a couple of years.

This rate hike cycle is truly unique because the Fed is unwinding its balance sheet, we have the biggest tax cuts in U.S. history while we have the largest national debt level ever at $22 trillion. With runaway deficit spending and a shortfall of tax revenue, the Treasury Department is selling increasing amounts of debt, which disproportionately affects longer dated bonds because buyers need to take into account the duration risk they are absorbing.

Another way to look at this is that an inverted yield curve is a sign bond investors believe the U.S. government is less likely to repay debt it owes in three-years, than it is in five-years. Bond investors therefore sell out of three-year bonds and buy five-year bonds. The selling out of three-year bonds pushes three-year yields up, while the buying of five-year bonds pushes 5-year yields down. If enough of this behavior occurs with bond investors, presto, we have an inverted yield curve.

The inverted yield curve explains why Jerome Powell did the “big pivot” last week. In October Powell said that rates were a “long way from the neutral rate”. By the end of November, Powell completely reversed himself saying that rates are “just below the neutral rate”. The inverted yield curve and what is happening in corporate bond markets has clearly freaked central bankers out. The Fed make a mistake by putting too much of an emphasis on inflation and ignored some major warning signs that I alerted you to back in mid-2018.

The bond market is quickly approaching the point where dealers have to ask themselves if a rate hike now increases the possibility of a cut in a couple of years.

The combination of higher bond yields and the looming threat of recession is adding to fears about slowing global growth.

Fed officials don’t like to talk about yield curve inversion, but earlier this year several members of the Fed’s rate-setting committee said it was a development they were watching which again explains why Powell reversed his position in just the last 7 weeks.

What concerns me is the crowding out effect where Powell has increased Treasury bond yields so much that it’s sucking money away from the private sector as evidenced by the spread between Treasury bonds and corporate bonds.

Treasury bonds are taking money away from the corporate bond market. This is known as the crowing out effect.

If the spread between investment grade corporate bonds and Treasury bonds climbs above 2%, the stock market and economy is toast. Recall what happened to this spread back in December 2007 when the economy went into a recession.

Treasury bonds and corporate bonds spread

While expectations still call for a rate increase later this month, for 2019 I’m thinking the Fed’s dot plot for 2019 will now show just one or two hikes compared to the prior expectation of up to four rate hikes.

I will continue to let Premium members know by email as the inverted yield curve situation develops.

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