Maybe you’ve heard the warnings…
The last three times this happened, painful bear markets followed…
And it’s teetering on the edge right now.
The warning we’re talking about is an interest-rate “inversion” – a rare situation in which short-term interest rates are higher than long-term rates.
Today, we’ll explain why an interest-rate inversion matters, both for the economy and the stock market. We’ll show you how past inversions have correlated with stock market crashes. And we’ll discuss what the current situation means for us as traders and investors now.
Let’s jump right in…
The specific interest rates we’re talking about today are on the two-year (short-term) and 10-year (long-term) U.S. Treasurys.
When you buy a Treasury, you’re loaning money to the U.S. government. And normally, the government needs to pay you a higher interest rate to tie up your money for longer amounts of time.
If, for example, the U.S. pays 1% per year on a two-year loan (a two-year Treasury), it might have to pay 3% per year on a 10-year loan (a 10-year Treasury).
This is the natural order of things because the risk of any loan increases with time… You might think you have a reasonably good idea of what will happen over the next year or two. But you don’t have nearly as good of an idea of what the world will look like in 10 or 30 years…
Will the U.S. still be the dominant world superpower? Will the U.S. dollar still be the world’s reserve currency? Will inflation be at 1% or 10%?
More time means more uncertainty. And more uncertainty equals more risk. So investors should demand a higher interest rate to compensate for higher risk.
Once in a while, though, yields invert… Short-term Treasurys (like the two-year) yield more than long-term Treasurys (like the 10-year). It shouldn’t happen, but it does. And it’s a clear sign that something is amiss in the markets.
You see, the Federal Reserve controls the shortest-term, “overnight” interest rates. This is the rate at which, in its role as the country’s central bank, the Fed loans money to corporate banks like JPMorgan Chase (JPM) and Bank of America (BAC).
The further out into the future that Treasurys mature, though, the less control the Fed has. It affects the supply of and demand for long-term Treasurys by buying and selling them… But global players in the financial markets influence long-term Treasury prices (and yields) far more than they do with short-term Treasurys.
All the reasons why interest-rate inversions happen and what they mean for the economy are topics for another day (or, more likely, a book or two). What you need to know now is that they’re not normal… and they tend to precede market drops.
The 30-year chart below shows the “yield spread” between the 10-year and two-year Treasurys. That is, it shows the yield on the 10-year Treasury minus the yield on the two-year Treasury. When the yield spread drops below 0%, yields (or rates) are “inverted.”
The bottom section of the chart (in blue) shows the benchmark S&P 500 Index. As you can see, not long after the yield spread inverts, stocks drop…
The last four times the yield spread between 10-year and two-year Treasurys crossed below 0%, stocks dropped an average of 40% soon after. And the spread just spent three days below that 0% level before rebounding back above it yesterday.
So, you might conclude, stocks are doomed. Right?
Here’s the thing… “Soon after” doesn’t mean “immediately after”…
On average, after yields inverted, stocks rose another 14% over the course of seven months. The quickest they peaked after an inversion was one month later (during which the S&P 500 rose 10%)… And the longest it took for stocks to peak after an inversion was 20 months (during which stocks rose 23%).
With that in mind, we don’t suggest you sell all your stocks right now.
Consider what happened in late 1994. The yield spread fell to as low as 0.07% on December 20 that year. That’s only marginally higher than Friday’s low of -0.08%. And boy, would that have been a bad time to get out of the stock market…
From December 20, 1994 to July 17, 1998, the S&P 500 soared 160%, with no more than an 8% pullback along the way. And after a 19% drop in July and August 1998 (which followed the first inversion in the chart above), the S&P 500 jumped another 60% to its March 2000 peak. In all, the S&P 500 rose 234% after the December 1994 near-inversion, before the Internet bubble popped.
In other words, a wide range of possibilities still exists for the stock market… even though the two-year Treasury yield just dipped below the 10-year yield.
If the spread climbs higher from here, we may be in a situation like late 1994. Stocks could post huge gains over the coming years.
If the spread continues lower and holds below 0%, we should get more cautious. But it doesn’t mean you’d need to sell immediately. You’d have a little time to reevaluate your approach…
In that scenario, you might slow down on bullish positions. You might tighten some of your stop losses. And you might look for trades that can benefit during down markets.
For now, though, it’s too soon to make any dramatic changes based on this often-cited (near) warning signal.
The S&P 500 is still in a long-term uptrend. And for now, we’re bullish. Our advice is to continue to hold your current bullish positions and look for new opportunities in stocks.
Good trading,
— Ben Morris and Drew McConnell
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Source: Daily Wealth