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Chart of the Day: US Treasury two-year vs 10-year yield curve

For anyone reading in the news about the inversion of the US Treasury two-year vs 10-year yield curve — the first since 2007 — it’s important to understand why this has resulted in the S&P 500 trading -2.9%, while we’ve also seen a strong bid in the JPY and bullish moves in gold.

Chart of the Day: US Treasury two-year vs 10-year yield curve

The yield curve effectively looks at the yield differential between various maturities of US Treasuries, with yield representing the expected total return investors can expect to get over the life of the bond. In this case, traders have looked at the fact that the yield on the US 10-year Treasury has traded with a lower yield than that of the shorter-term two-year Treasury — for the first time since 2007. The concern in markets stems from the idea that the flattening of the curve into inversion is a sign that US monetary policy is simply too tight for the levels of growth and, ultimately, inflation seen in the US economy.

As we can see with the red shaded areas, which represent prior periods of recession, we see the US head into a recession after a lag. This inversion is therefore often seen as the trigger for what could be. And the idea that the US is headed for tougher times has resonated in the market.

Ironically, the trend towards an ever flatter curve is actually very mature, and shouldn’t shock. However, the mere fact in which we saw this yield differential turned negative and witnessed traders punish risk assets makes one suspect that this must be psychological.

What’s important now is the inversion is just the starting point. While the word recession has been used far more liberally, as we can see on the chart, it isn’t until the curve starts to steepen again — with two-year yields falling faster than 10-year yields — will we actually see a recession play out. This is often when the Federal Reserve starts an aggressive easing cycle, causing investors to buy short-term bonds (yields lower); hence, the steeper curve.

To give context: The last inversion took place on 27 Dec 2005, but the recession actually started formally 24 months later. So, we take this signal as a sign the Fed needs to be more aggressive with its easing policy. It also isn’t hard to see why US President Donald Trump has been vocal on social media about this.

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