Bond markets sent a stark message on Tuesday: The current economic expansion — the second longest on record — might not be long for this world.
Stock investors heard it loud and clear, and, along with confusion about the status of a trade-war truce with China, it helped push the S&P 500 stock index down more than 2 percent in afternoon trading.
The warning from the bond market came through what’s known as the yield curve, essentially the difference between interest rates on short-term United States government bonds, such as two-year notes, and longer term bonds, such as the 10-year Treasury.
As wary investors seek security, they buy long-term Treasury bonds, pushing prices up and pushing down yields, which move inversely to prices. The yield on the two-year note tends to move along with the short-term rates controlled by the Federal Reserve; both have risen this year.
The gap between the two-year and 10-year yields has decreased to less than 0.12 percentage points — the lowest it has been since before the financial crisis. Many analysts say it could soon fall below zero, a phenomenon known as an “inversion.”
This might sound like so much jargon important only to bond market geeks. But it matters.
“The inversion has always preceded the recession so you can’t just pooh-pooh it and say this is some crazy forecaster who is telling us the world is going to end,” said Vinay Pande, head of trading strategies at UBS Global Wealth Management’s Chief Investment Office.
In the past 60 years, every recession has been preceded by an inverted yield curve, according to research from the San Francisco Fed. Curve inversions have “correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession,” the bank’s researchers wrote in March.
That doesn’t mean the next recession is imminent — it can take a year or two for an inverted yield curve’s recession warning to come to fruition. Nor does it mean that the stock market rally will immediately come to an end. The yield curve also narrowed earlier this year also, and the stock market mostly ignored it then.
But this time, with investors already worried about the global economy and the effect of the trade war on growth, the warning is being seen in a different light. The United States’ economy is growing at a healthy clip, but China’s is growing at its slowest rate in a decade. The world’s third largest economy, Japan, shrunk during the third quarter, as did Germany’s.
Stocks also fell on Tuesday after President Trump added to uncertainty about the trade-war related agreement he reached with China’s president over the weekend by tweeting a warning to China and referring to himself as “Tariff Man.”
The S&P 500-stock index, which had climbed more than 1 percent on Monday following news that the two countries had agreed to a standstill on additional tariffs, was down by more than 2 percent in afternoon trading.
The financial sector was one of the hardest hit segments of the market Tuesday, tumbling more than 4 percent. A flattening yield curve hamstrings profitability for banks, which benefit from a wide difference between short-term rates, which they pay to borrow, and long-term rates, which they charge their customers.
Stocks of so-called cyclical companies — which are heavily reliant on economic growth for sales and profits — also slumped on Tuesday. Shares of airlines such as American Airlines, Southwest and Delta Air Lines, slipped. The S&P 1500 index of automakers and auto parts — another highly cyclical sector — fell more than 2 percent, worse than the overall market.
There are several reasons the flattening of the yield curve is seen as such a good predictor of recession.
Typically when an economy is in good health, yields on longer-term Treasuries are higher than those on shorter term government bonds, reflecting investor expectations that economic growth, and some inflation, will continue in coming years. When investors become less sure of that the economy and prices will continue to rise, yields on longer term bonds rise slowly, or even fall.
That’s been the case lately. Despite solid domestic economic growth and unemployment near 50-year lows, the yield on the 10-year Treasury note tumbled to 2.94 percent on Tuesday, down from 3.25 percent in September.
And other markets have also been sending some signals about softness in the global economy. American benchmark crude oil prices have plummeted more than 25 percent since the end of September.