Mixed Signals

In a classic case of the tail wagging the dog, the bond market is signaling that the U.S. economy is headed for a recession, rather than the economy telling the bond market that news, which it doesn’t appear to be doing.

On Wednesday, yields on the benchmark 10-year Treasury note fell below two-year yields for the first time since 2007. “This kind of inversion between short and long-term yields is viewed by many as a strong signal that a recession is likely in the future,” according to the Wall Street Journal. Except, of course, when it doesn’t, and this just may be one of those times. The economy, albeit weaker than it was late last year and earlier this year, doesn’t seem to be close to a recession.

Actually, Treasury yields have been inverted for a while, depending on which spread you look at it. At the same time, yields along the curve have dropped sharply in recent weeks, with some securities dropping to record lows.

For example, on Thursday, the yield on the 30-year bond dropped below 2.0% for the first time ever. That’s down from 3.45% on Halloween. The 10-year yield plunged below 1.60%, down from 3.16% last October 1 and it's lowest level since it hit 1.46% three years ago in July.

Meanwhile, the price of gold has jumped 18% since May to more than $1520 an ounce, its highest level in more than six years. And of course, stocks are down, with the S&P 500 off more than 6% since hitting a record high just a couple of weeks ago.

Why is the market so panicky?

According to market prognosticators, it’s all about the trade war. However, their concern about that doesn’t seem justified, either as it relates to the U.S. economy or that there is something new for investors to be worried about.

We have been hearing about the trade war for the better part of a year now. It’s not simply a war of words between the U.S. and China – tariffs really are being raised and then counter-raised. The fact is, though, that there really is nothing new going on here, yet the market goes up and down in reaction to each country’s move, like the crowd at a tennis match oohing and aahing during a fierce volley exchange.

At the same time, the market has lost sight of just how impactful trade is to the U.S. economy, which is a lot less than the market reaction would lead you to believe. According to most estimates, only about 10% of the U.S. economy is tied to trade, which is a lot less than those of China, Japan, and Europe. The American economy doesn’t operate in a vacuum, for sure, but the market is clearly overreacting to how big a threat this is.

We seem to have forgotten that the American economy is still in good shape, as Jerome Powell and his colleagues at the Federal Reserve keep reminding us, even as they keep indicating that they’re ready to give said economy another shot in the arm with monetary accommodation – read an interest rate cut.

So, who do we have to thank for this confusing state of affairs? Why, the Fed, of course.

The Fed and other central banks have so distorted the bond market through their constant bond-buying and monetary accommodation – whether it’s needed or not – that it’s no wonder that the yield curve is inverted. At the same time, the Fed has basically told the markets that it will intervene at the slightest sign of trouble – not for the economy, but for asset prices – that the markets assume the Fed will constantly provide the needed elixir. In other words, bond yields are being set artificially, not by economic and supply-and-demand forces but by central bank manipulation, so to read a recession into inverted yield curves seems a little misguided.

The market now seems to be set in a bad-news-is-good-news mindset, based solely on what the Fed might do in reaction. If a good economic report comes out, that’s bad news, since it makes it less likely the Fed will cut rates again. Conversely, if weak news comes out, that’s good, since it gives the Fed a reason to cut.

The fact is, though, that the Fed has no sound reason to lower rates again. Its rationale for cutting the federal funds rate in July was a little flimsy, so much so that two members of the Fed voted against the move, an unusual event in itself. Doing so again in the near future would be an even bigger stretch, and distort the markets even more.

As we can see from the experience in Europe and Japan, super-low interest rates – even the negative variety – have done absolutely nothing to boost their economies. Instead, they’ve further weakened their banking systems by making it extremely difficult for their banks to make money, and made the wealth gap between rich and poor wider than ever.

Here we are, 10 years after the financial crisis, and central banks can’t keep from trying to manipulate markets.

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George Yacik
INO.com Contributor - Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.

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