3 Reasons to Worry About the Inverted Yield Curve

inverted yield curve - 3 Reasons to Worry About the Inverted Yield Curve

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Inverted yield curve concerns are back, and they are creating a significant drag on financial markets. On Friday, March 22, the yield curve inverted further, including an all-important inversion between the 3-Month and 10-Year Treasury yields. The S&P 500 consequently had its worst day since early January.

But, is this something to really worry about? After all, wasn’t it an inverted yield curve that sparked the big late 2018 global market selloff? Financial markets have recovered in a big way since then. Will markets likewise shrug off this inversion, too?

Yes and no. Yield curve inversions in late 2018 were in the middle part of the yield curve, and weren’t all that meaningful. Now, the yield curve is inverting on the long end, and that’s scary, because long-end inversions tend to predict recessions. To be sure, though, this inversion hasn’t lasted long enough nor is it big enough to be considered a true long-end inversion, and even true-long end inversions tend to happen more than a year ahead of a financial market peak.

As such, this most recent yield curve inversion is a warning sign, not a stop sign. Stocks should head higher from here, but investors should be more cautious in their investment strategies going forward.

This Is the Scary Inversion

The late 2018 yield curve inversion was in the middle part of the curve, and wasn’t all that meaningful in terms of forecasting a recession.

Specifically, the yield curve first inverted in mid-December when the two-year yield flipped above the three-year yield. By the end of 2018, the inversion spread, with the one-year yielding above the seven-year. But, the all-important 10-Year Treasury yield has been largely left out of the inversion.

Until now. On March 22, the 10-Year Treasury yield sunk on slowing global growth concerns. It dropped below the one-year Treasury yield and the three-month Treasury yield. That’s a big deal. It means that the inversion has spread to the long ends of the yield curve, and as Wells Fargo points out, these long-end inversions are the ones that matter when it comes to predicting a recession.

To be sure, long-end inversions need to last several weeks and widen out to a 25 basis point spread before being meaningful. We are a long way away from hitting either of those levels. But, the 10-Year, three-month inversion is the big scary one that investors have been dreading for several months. As such, caution is warranted with this spread now in negative territory.

Growth Is Slowing

The yield curve didn’t invert without reason. The world’s biggest bond market is reflective of the reality that growth globally is slowing to multi-year lows.

For starter’s, China’s economy is slowing rapidly and is now growing at its slowest rate in over a decade. That’s a big deal for the global growth narrative since China has been the biggest contributor to global GDP growth for the past several years. Meanwhile, growth throughout Europe is slowing, with 2019 and 2020 GDP growth estimates across the whole continent falling. U.S. GDP growth estimates are also dropping.

Against this slowing global growth backdrop, S&P 500 companies are reporting slow growth numbers. Revenue growth for the S&P 500 in the first quarter of 2019 sunk to a multi-quarter low, while aggregate earnings growth was negative on a year-over-year basis for the first time in nearly three years. Further, an above-average number of S&P 500 companies are issuing negative guides for next quarter, too.

All in all, growth is slowing everywhere. An inverted yield curve against this backdrop likewise warrants caution going forward.

Valuations Aren’t Cheap

Back in late 2018, one thing working for bulls was the valuation argument. Quite simply, stocks were too cheap. That argument, however, has lost favor in early 2019 as markets have rallied.

Specifically, in late 2018, the S&P 500’s forward price-to-earnings multiple dropped below 14. That marked a multi-year low valuation level, and was significantly below both the market’s five-year and 10-year average forward P/E multiples.

Now, though, the S&P 500 has rallied back to near all-time highs, while EPS estimates have come down due to slowing growth concerns. The net result is that the market is trading at 16.6-times forward earnings, above both the market’s 5-year and 10-year average forward P/E multiples.

In other words, in late 2018, you had a stock market that was dirt cheap and a yield curve that was only partially inverted. That combination created a compelling buy the dip argument. Now, you have a stock market that isn’t dirt cheap, and a yield curve that is fully inverted. That combination makes for a far less compelling buy the dip argument.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities. 

Article printed from InvestorPlace Media, https://investorplace.com/2019/03/3-reasons-to-worry-about-the-inverted-yield-curve/.

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