The ‘yield curve’ explained and how it became Wall Street’s barometer

Investing


The rate on the 2-year note is inching closer to that of the 10-year, making that ordinarily upward sloping curve flatter. The 2-year rate is dangerously close to rising above the 10-year, in fact. That creates a topsy-turvy condition Wall Street analysts like to call “inversion,” where the line of the slope shifts downward.

If the historic pattern holds, an inverted yield curve would mean recession is on the horizon. It won’t be immediate, but recessions have followed inversions a few months to two years later several times over many decades.

“In a longer range chart going back to 1962, there has never been a recession that wasn’t preceded by an inversion of the yield curve,” explained Bespoke Investment Group in a note to clients earlier this year.

The rate on the 2-year has already jumped above the shorter-term 5-year note, a move that suggests the “economy is poised to weaken,” DoubleLine Capital’s Jeffrey Gundlach told Reuters in an interview on Tuesday. Gundlach, a noted bond investor, has been warning investors to be cautious.

Gundlach’s comment and increased fears about an economic slowdown pushed the Dow Jones Industrial Average down as much as 600 points at midday on Tuesday.

Some traders are focused on what these shifts in the bond market signal for the stock market, which has been on a nine-year bull run. At times when the curve has inverted, the S&P 500 was down an average of 1.9 percent 12 months later.

Michael Darda, the chief economist at MKM Partners, says people may be too focused on the wrong data. “Recession forecasting is fraught with difficulty, so it’s important that we don’t make it more difficult than it has to be by focusing on the wrong indicators, or, at a minimum, less reliable ones,” he said in a note Tuesday, pointing out that the difference between the 2- and 5-year rates are not reliable indicators.

It is the difference between the 10-year and the 1-year that everyone should worry about, he said, and that shows no inversion, yet.



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