The market is sending warning signals. Here’s what it’s saying, and when it’s likely to happen
Investors are always looking for clues as to what’s going to happen next in the markets. This week, we received one such clue … and it’s suggesting caution.
In short, the feared “yield curve inversion” is back, and it doesn’t bode well for the stock market.
On Wednesday, the yield curve inversion between the 3-month Treasury bill and the 10-year note widened to its deepest level since the financial crisis. We saw a premium of 10 basis points for holding 3-month bills instead of 10-year notes.
For any readers who are less familiar with bonds and yield curves, let me quickly get you up to speed.
***The yield curve is a graph that shows the interest rate yield of bonds (of the same quality) over varying maturities
Most of the time, under normal circumstances, shorter maturities have a lower yield than the longer-dated maturities, such as in the chart below.
This makes sense — investors typically expect a higher return in exchange for tying up their money for a longer period.
But when the yield curve inverts — which is abnormal — short-term rates move higher higher than long-term rates.
Many investors see this as a serious sign of trouble. That’s because they interpret it as meaning there’s more risk in the short-term than the long-term. Some analysts even see this as a sign of a looming recession.
Of course, while an inversion has been a somewhat reliable recession indicator in the past, that doesn’t mean a recession — or even a major stock market pullback — is going to happen tomorrow.
Also, the more important bond spread is the one between the 10-year and the 2-year — and as of the time of this writing, that has not inverted (though yields are dropping on Friday as the markets are under pressure).
Back to this week’s inversion …
We saw the 3-month bill yield rise to 2.362%. Meanwhile, the 10-year note yield dropped to 2.26%. Below, you can see how this looked, as well as the steadily falling 10-year yield as 2019 has progressed. Also notice the brief inversion from earlier this spring.
***Moving beyond the basics just described, what’s really happening with a yield curve inversion, and what does it mean for your portfolio?
To dig into these details, let’s turn to John Jagerson and Wade Hansen, editors of Strategic Trader. John and Wade are two of the best technical traders in the business, as evidenced by their astonishing record of 80 straight closed, profitable put trades (averaging an annualized return of 47.38%).
On Wednesday, John and Wade began their update to subscribers by describing the interplay between bonds and stocks, noting how, historically, bonds have been a leading indicator.
Historically, the bond market has been a leading indicator for the stock market. You can see this relationship below.
As you can see, the bond market tends to bottom out and rebound before the stock market. It also tends to peak and decline before the stock market …
John and Wade then explain what’s behind this “leading indicator” phenomenon.
Basically, when bond traders are feeling confident about the economy, they expect that inflation is going to rise based on that coming economic strength. That would likely mean new bonds will have higher interest rates.
Given this expectation, these traders sell the bonds they currently hold (with lower rates), which drives bond prices lower and yields higher. (Bond prices and bond yields have an inverse relationship.)
On the flip side, when traders fear an economic contraction, they’re worried about deflationary pressure. That would likely result in lower interest rates. Given this, traders buy bonds today, which pushes prices higher, driving yields lower.
Back to John and Wade:
That is exactly what is happening right now. Bond traders are pushing bond prices higher and driving bond yields lower.
You can see this in the chart of the 10-year Treasury yield (as represented by the TNX) below.
The TNX broke below down-trending support to a new 52-week low of 2.27% on Tuesday.
The 30-year Treasury yield (as represented by the TYX) isn’t doing any better.
The fact that both of these yields are below 3% and falling is a clear signal that bond traders are losing confidence in the potential strength of the U.S. and global economies as we approach the second half of 2019.
***John and Wade then note the yield curve inversion and interpret its significance
The yields on Treasuries from the 1-year Treasury note through the 10-year Treasury note are all lower than the yield on the 1-month Treasury bill. John and Wade tell us that this phenomenon is called an inversion of the “belly” — or middle — of the yield curve.
Back to John and Wade:
When you see the yield curve inverting, you know bond traders are worried the economy is going to slow down. Currently, the inversion of the yield curve is getting worse. From the beginning of May until now, the belly of the curve has dropped dramatically.
Seeing the Treasury yield curve continue to invert like this is a huge red flag from the bond market …
However, it is important to remember that while the bond market is often a leading indicator for the stock market, it takes time for these signals to play out. Just because the bond market starts to turn around doesn’t mean the stock market is going to automatically turn around within the next week. These major shifts can take months to play out.
***Given this bearish tone, I reached out to John yesterday to get more clarity on where the market might be going … and just as importantly, when
Regular Digest readers likely remember market studies from John over the last two weeks. These analyses, which have factored in historical market action, have actually suggested shorter-term market strength.
Of course, this week has seen lots of selling pressure, and John and Wade’s analysis of the yield curve sounds bearish, so I wanted to better understand what appears to be conflicting data.
Jeff: Help me understand how the recent market studies you’ve done, that are generally bullish, fit in with this yield curve analysis, that’s largely bearish.
John: It’s more a difference in timing. If someone asked me to evaluate the short-term prospects for the market, I would say that the market is volatile right now but historically, these bearish patterns have a very high failure rate with a surprisingly strong bias for short-term moves to the upside after they fail.
So, in the short-term, one to three months, I would still suggest that the market has potential upside once this period of volatility is over.
However, if I had to make a long-term forecast for the end of 2019 and into 2020, based on the information we have from the bond market, my outlook is much more bearish.
Jeff: How much weight should we put on this yield curve inversion? Is it that reliable of an indicator?
John: Signals from the treasury bond market have very high reliability but they also have a long runup before they have an effect on the stock market. The last time we had signals like this, it took 18 months before the market really turned south. In general, the average is about 11 months.
Jeff: So, can you give us a bottom-line takeaway that includes both short-term and long-term expectations?
John: We are still long and looking for new bullish opportunities but are being picky about entry prices. However, if nothing changes over the next six months then we should be managing much more aggressive hedges to protect our portfolio before the market turns south.
The mistake that most new traders make is to confuse long-term issues with short-term forecasts. Unless something changes, the bond market says stocks are in trouble six-to-twelve months from now and we need to pay attention. The last time we saw a signal like this was late 2006, and the market eventually lost half its value but it rose another 20% in the 12 months before doing that.
***So, with the current information we have, John is suggesting we could see the market push higher in the shorter-term, but there are red flags further out unless something changes
Here in the Digest, we’ll be watching market signals to get a sense of where we’re going and will update you as 2019 progresses.
On a side note, over the past two weeks of Digests, when I’ve referenced John and Wade, you might have seen their track record change from 78 straight winners, to 79, and now 80 consecutive, profitable, closed put trades. More interestingly, their average annualized yield on the trades has gone from 35.7% to 47.38%.
The reason for this increase is because the market has been more volatile over the last few weeks. This has led to an increase in the prices of the options that John and Wade sell. So, while many investors are watching the markets anxiously, John and Wade have actually been generating more income based on those market jitters. If you’d like to learn more about this powerful, income-generating strategy, click here. In the meantime, we’ll keep you up to date on the yield curve.
