5 Things to Know About the Yield Curve and Market Volatility

5 Things to Know About the Yield Curve and Market Volatility

The volatility illustrates the tug of war between investment opportunity and risk.

Market volatility returned in recent weeks, with equity market swings of 1% or more becoming a daily occurrence. Day traders may be the only investors enjoying the sudden changes in market sentiment, and low summer trading volumes may be magnifying market moves.

Market turbulence often creates fight or flight investment responses.

Investors should know the following five things about today’s trade war, market volatility and the inverted yield curve:

  • Yield curve inversion is an indication that recession risks are mounting.
  • Economic growth is weakening in much of the world.
  • Fed Chair Jerome Powell isn’t to blame for the economic slowdown in the U.S.
  • The economic slowdown in China was primarily “made in China,” not in the U.S.
  • Both sides are losing the trade war.

Yield Curve Inversion Is a Sign of Increasing Risk

Three-month Treasury bonds have yielded more than 10-year Treasurys since late May. Two-year Treasurys briefly yielded more than 10-year Treasurys on Aug. 14 – the first such occurrence since 2007. And, 30-year Treasurys yield less than 2%, in a shocking turn of events for long-time bond investors.

Inversion of the yield curve has been a reliable predictor that a recession is coming, though there is often a long lag between inversion and recession.

The inverted yield curve is a symptom of investor concern about economic growth but is far from a guaranty that the current economic slowdown will turn into a recession.

The yield curve could “normalize” in one of two ways.

The Federal Reserve is likely to cut short-term rates in September, perhaps by as much as half of 1%, if economic growth continues to stall and trade tensions persist. The Fed’s actions conceivably could be enough to bring short-term rates back below long-term rates.

The yield curve could also normalize in response to a resumption in economic growth or an easing of trade tensions. Given a more favorable economic backdrop, long-term rates could rise back above short-term rates.

Global Economic Growth Is Weakening

The euphoria that followed President Donald Trump’s announcement delaying part of the next round of tariffs on Chinese goods proved to be short-lived, as equities and bond yields fell.

Disappointing retail sales growth and industrial production in China and a contraction in the export-centric German economy were among the catalysts for the market slide on Aug.14.

Signs of weakness are showing up in U.S. economic data as well. U.S. manufacturing activity fell close to three-year lows in July, evidence of the impact of trade tensions and slowing growth outside the S&P 500 earnings and revenue growth were uninspiring in the second quarter, with multinational companies among the hardest hit by trade tensions and the strong dollar.

Growth certainly appears to be slowing in both the U.S. and China, but there is a big difference between a slowdown and a recession.

Powell Shouldn’t Be Blamed For the Slowdown

Trump claims that Fed Chair Jerome Powell is responsible for slowing U.S. economic growth. Although the Fed’s December rate hike looks like a policy error in retrospect, Fed policy isn’t the primary cause of slowing economic growth.

U.S. interest rates remain reasonably low and credit availability does not appear to be a problem for most companies and consumers. Consequently, it seems inappropriate to assert that the Fed bears primary responsibility for the growth slowdown.

If low rates were a cure-all for economic growth, Europe and Japan would have booming economies! The steep drop in agricultural exports and slowing business spending is largely attributable to the trade war between the U.S. and China, not Fed policy.

Rate cuts won’t fully compensate for the drag on business activity and sentiment caused by trade tensions.

China Is to Blame For Its Own Slowdown

China’s President Xi Jinping is appealing to nationalist sentiment in China by blaming China’s economic slowdown on tariffs and trade restrictions imposed by the U.S.

Trade tensions aren’t helping Chinese economic growth, but the roots of China’s slowdown are in policy decisions made by Chinese leaders to address structural concerns. Tightening of the non-bank credit sector, which provides funding to consumers and private enterprises, was a major factor in the slowdown that started last year.

Although China has eased monetary and fiscal policy this year, stimulus efforts haven’t been strong enough to provide the eagerly anticipated boost to Chinese and global growth.

Both Sides Are Losing the Trade War

A trade war isn’t easy to win. The only winners of the U.S.-China trade war may be countries such as Vietnam that benefit from realignment of supply chains.

In addition, U.S. and China may both be overestimating their bargaining leverage. The U.S. may be overestimating the damage that tariffs are causing the Chinese economy, while underestimating China’s ability to stimulate its economy and retaliate against the U.S.

China’s apparent attempt to delay talks or inflict enough pain on the U.S. to get a more pliable negotiating partner in the White House may also backfire. Trump’s popularity in farm states does not appear to be wavering and frustration with China appears to be a bipartisan issue in the U.S.

Recessions are not a recipe for re-election, which should ultimately motivate Trump to find enough common ground with Xi to declare a pre-election “cease fire” in the trade war.

The most successful investors channel their emotions into analysis before giving into fight or flight impulses. The volatility of recent weeks illustrates the tug of war between opportunity and risk in an investment environment in which upside potential coexists with meaningful downside risk.

Source: U.S. & World Report News
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