Alert! Recession dead ahead!
That was the message the infamous yield curve sent out on Tuesday.
This time, the inversion was related to yields for 10- and 3-year Treasuries.
Ongoing U.S.-China trade negotiations. Since they fell apart, investors have been flocking into safe-haven assets, such as longer-term U.S. Treasuries.
This surge in demand has pushed prices up… causing yields to drop (bond prices and yields are inversely related).
Over the last year, we’ve seen plenty of long-maturity over short-maturity inversions. But what makes this one special is that it’s the one Fed Chairman Powell has indicated he’d watch out for when setting policy.
It’d seem the inversion is sending a clear message—namely, that it’s time for Powell to lower interest rates.
Where U.S. Treasuries Move, Fed Interest Rates Follow
Another reason I believe this will play out is the decoupling between 10-year Treasury yields and Fed rates, which had been moving in the same direction until November 2018, when 10-year Treasury yields dropped.
This happened because the 10-year Treasury is more sensitive to deteriorating global financial conditions, while the Fed rates are a function of U.S. market factors. However, considering that foreign trade represents nearly a third of U.S. GDP, the situation abroad will inevitably impact the domestic economy. Therefore, it’s impossible for interest rates to stay where they are. More likely, they will follow the 10-year Treasury.
I expect Fed Chairman Powell to change his narrative to a more dovish tone at the June Federal Open Market Committee (FOMC) meetings and signal an interest rate decrease.
Powell Will Step In If Stock Markets Fall Below These Levels
One event that could prompt Powell to react even sooner would be a rapid stock market decline.
We’ve seen him do it before, during the December stock market blues, when all indexes dropped by at least 8.7% for the month on concerns that the Fed was tightening financial conditions too quickly.
Powell’s comments that the Fed will be “flexible” on its policy and is not “in a hurry” to raise interest rates was just the message the markets needed to hear.
This time, however, he won’t wait as long to deliver it.
In December, markets dropped well into bear territory before Powell responded—understandably, as global economic conditions were not as bad as they are now and U.S. markets were still riding the Trump tax-break wave.
Today, the situation is entirely different. U.S.-China trade negotiations have fallen apart. It will be some time before we see a deal or a reduction of tariffs. As a result, the global economy has slowed substantially.
Moreover, there is no fiscal stimulus—such as the Trump tax break—on the horizon to reverse the trend.
The key indicator you should watch out for is a decline below 2,700 levels on the S&P 500 and below 25,000 on the Dow Jones. That’s when Powell will feel compelled to step in and lower interest rates…
And we all know what happens next.