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Here’s another scary sign from the bond market

Posted at 12:09 PM, Jul 08, 2019
and last updated 2019-07-08 14:09:10-04

Something happened in the bond market last week that has occurred before five of the past six major market meltdowns.

The yield on the benchmark 30-year US Treasury bond — the lesser-known but still important fixed income cousin to the 10-year — briefly dipped below 2.5%. In other words, the 30-year was yielding less than the Federal Reserve’s short-term federal funds rate.

It’s yet another example of the craziness in the bond market right now. It costs less to borrow money for a period of decades than just a few months — a phenomenon known as an inverted yield curve.

The most widely watched yield curve, measuring the difference between the rates for the 3-month US bond and 10-year Treasury, flipped in late May.

The inversion of the 30-year and federal funds rate has happened only six times since 1980. And five of those times it took place just before a significant pullback in stocks: the double-dip recessions of 1980-1982, the savings and loan crisis of the late 1980s, the Asian debt crisis of 1997, the bursting of the tech bubble in 2000 and the Great Recession of 2008.

Tavi Costa, a global macro analyst with Crescat Capital, noted that historical trend in a tweet last week. The only time in the past four decades when the 30-year yield fell below the fed funds rate and was not followed by an immediate crisis was 1986, he added.

Time to bet against stocks?

Speaking to CNN Business on Monday, Costa said he is worried this most recent yield curve inversion could be a sign that the stock market will soon hit a very rough patch.

Costa said the shape of the yield curve isn’t the only warning sign. He noted that stock valuations are rich since the market remains near all-time highs.

He added that the job market could be close to peak levels as well given the low rate of unemployment.

“We are very late in the business cycle. It’s compelling to bet against stocks,” Costa said. “It’s a Goldilocks scenario with low inflation but that tends to happen towards a peak for the markets.”

Costa conceded that stock market pullbacks don’t always go hand in hand with economic downturns.

But he said the S&P 500 may be overvalued by as much as 40%. If stocks were to lose that much in value over a short period of time, it’s hard not to imagine how the United States could avoid a recession, Costa added.

The Fed may come to the rescue again

Still, others think that the Federal Reserve could help prevent a severe downturn, saving the day with interest rate cuts.

The strong jobs report on Friday may have dimmed hopes that the Fed will lower rates by a half a percentage point.

But the market is still pricing in a quarter-point cut at the Fed’s next meeting on July 31. There could be more cuts later this year if the economy loses momentum.

“We’re still on track for a rate cut,” said Odeta Kushi, deputy chief economist with First American.

Kushi told CNN Business she thinks the Fed is likely keeping a close eye on the fact that wage growth slowed slightly in the June jobs report, adding that the US trade war with China and several other nations could hurt the US manufacturing sector.

Bill Stone, chief investment officer with Avalon Advisors, also thinks the Fed will step in to help prevent a severe US downturn. What’s more, he pointed out that the market has tended to still do well for awhile even after the yield curve inverts.

“Stocks have historically had significant advances post-inversion,” Stone said in a report. “The market expects about two net cuts in short-term rates over the next year and a half. Our view remains that the odds of a recession in 2019 remain low.”

R.J. Gallo, senior portfolio manager with Federated Investors, agrees.

“The fact that [the yield curve] is inverted suggests that the market is highly confident that the Fed is going to have to ease,” Gallo said in a recent video message for clients.

Gallo added that if the Fed acts quickly and most major trade complications can be resolved, the United States will likely avoid a recession in the near-term — even though the yield curve is flashing a big yellow caution sign.