Brace for a 15% plunge in S&P 500 next year if the Treasury yield curve fully inverts
- Bond market is already firing a warning shot, says Oliver Jones, a Capital Economics analyst -
Parts of the U.S. bond market are seeing short-dated yields push above their long-dated peers, a "warning sign" for the stock market as Wall Street's economic expectations for 2019 deteriorate.
That's what Oliver Jones, an analyst for Capital Economics, said in a recent note, as investors pay newfound attention to the yield curve, the spread between short-dated and long-dated yields. Jones and others are worried that if this gap continues to narrow, more losses will follow for the S&P 500 which has already been retreating from its October highs.
"History suggests that once the Treasury yield curve becomes very flat or starts to invert, the stock market tends to struggle over the following couple of years, as the economy eventually starts to weaken," said Jones.
The widely-watched gap between the 10-year note and the 2-year note narrowed to 11 basis points, according to Tradeweb data. And less common pairings used to assess the curve's slope such as the spread between the 3-year and the 5-year, along with the 2-year and the 5-year inverted on Monday.
The curve's flattening trend has sent shivers through the stock market. The S&P 500, Dow Jones Industrial Average and the Nasdaq Composite closed down more than 3% on Tuesday.
When short-term yields exceed their long-term counterparts, inverting the curve, a recession has usually followed. In the last nine times when the spread between the 2-year and the 10-year turned negative, economic growth has ground to a halt.
Admittedly, the timing between an inversion and a recession can vary from six months to as much as two years. That means stock-market investors may be tempted to stick through the recent market volatility and try to reap the benefits of robust growth, as the world's largest economy is still expected to expand at a healthy 2.5% clip in 2019, according to economists polled by MarketWatch.
Yet Jones says investors may not want to take any chances. In the chart below, he shows that whenever the spread between the 2-year note has matched or pushed above the 10-year note yield, the S&P 500's returns over the next two years has turned negative. He expects the S&P 500 to slump 15% in 2019.
The yield curve's predictive abilities as a recession indicator has troubled investors who see the strong economic tailwinds that had propped up the U.S. economy in 2018 fading. Uncertainty from tariffs have helped undercut corporations' incentives to invest in their own businesses. While, the stimulus from the tax cuts passed in early 2017 may no longer serve as a powerful boost to growth in the coming years.
Jones admits that short-dated yields remain lofty thanks to a Federal Reserve that still holds the economy's prospects in high regard, enabling it to raise key rates without fear of undercutting growth. New York Fed President John Williams said Tuesday that the strong outlook for the U.S. economy meant the central bank would continue to raise rates in a gradual fashion.
The 2-year note ended at 2.811%, down from its multi-decade high of 2.969% reached on Nov. 8. But the short-dated maturity traded well above where it started at the year, which was 1.891%.
The 5-year yield closed Tuesday at 2.797%, and the 10-year yield ended at 2.911%, according to Dow Jones Market Data.
"The fact that the yields of the shortest-dated bonds have held up presumably reflects the fact that the U.S. economy is in good health for now, and that the Fed has signaled fairly clearly that at least another couple of rate hikes are likely," said Jones.
But the pullback in core inflation and crude-oil prices raise questions about "how long growth in the U.S. can remain so strong," he said.
From MarketWatch