Dollar weak as U.S. Treasury yield curve inversion sparks recession fears

Irving Hamilton
December 7, 2018

World stocks tumbled to one-week lows on Wednesday, as declines by long-dated us bond yields and a renewal of trade concerns stoked fears of a downturn in the world's biggest economy, the United States.

On December 4 the yield curve signaled caution and, along with worries about global trade and interest rates, it helped send the stock market to one of its worst days of the year.

The dollar index, which measures the greenback against a basket of six major currencies, edged up about 0.1 per cent, even though the US currency was under pressure as declining Treasury yields raised concerns over economic growth.

Markets across the world have been rattled by recession fears, exemplified by the flattening U.S. Treasury yield curve. But when investors are anxious that growth will fall off sharply, perhaps as a result of the Federal Reserve pushing short-term rates higher, they're willing to accept less in interest for a Treasury maturing far in the future. One portfolio manager called the inverted yield curve a "harbinger of doom". On Monday of this week, the USA government's five-year bond yielded less interest than the three-year bond.

The 3-month to 10-year spread is now 0.492 percentage points.

No, at least not yet.

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The dollar has been under pressure since Federal Reserve Chairman Jerome Powell said last Wednesday that USA interest rates were nearing neutral levels, which markets interpreted as signalling a slowdown in the pace of rate hikes. Shanghai markets fell 0.6 per cent, their losses limited by Chinese officials expressing confidence that a trade deal would be clinched on time.

"This solidifies not only my flattening bias but I think it will lead many players in the market who [expected the yield curve to steepen] to capitulate on that", Ian Lyngen, the head of united rates strategy at BMO Capital Markets, told CNBC.

Whether or not the 3-month to 10-year spread inverts may very well depend on how many more hikes the Fed gets in.

That tipping point has preceded most U.S. recessions since 1950, and the curve last inverted in February 2006 prior to the 2008 recession. The Dow Jones Industrial Average closed down almost 800 points, or 3.10 percent, and the Standard & Poor's 500 fell over 90 points, or 3.24 percent. Of course, that's still "pretty doggone tight", said Randy Frederick, vice president of trading and derivatives at Charles Schwab. Morgan Stanley recently forecast about a 50-percent chance of a mild "earnings recession" in 2019, which is defined as two consecutive quarters of year-over-year declines in S&P 500 earnings.

The Cleveland Fed, meanwhile, has focused on the difference in yields between three-month Treasurys and 10-year Treasurys.

"Inversion of that curve is the real recession red flag", said Neil Wilson, the chief market analyst at Markets.com. When the yield curve inverts, it means the two-year notes pay bondholders more in interest than 10-year notes do, something that's both rare and counterintuitive. The usually unremarkable "yield curve" made investors sit up and take notice this week as it signaled a possible recession on the horizon, sending stocks plummeting. There have also been false positives in the past, where the yield curve has inverted but no recession has followed, such as in 1966.

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