The size and scope of the message coming from the treasuries market keeps getting stronger.
Overnight, the US 2-year and 10-year yield inverted for a fifth straight day, posting the largest inversion since 2010.
The message it is sending is getting clear. It’s risk-off versus risk-on.
Risk aversion is growing as bond traders review the list of persistent uncertainties. These include fresh Covid-19 cases emerging from China, the strength of the US dollar and what headwinds it presents to other currencies, concerns if we are in a stagflation environment and, of course, fears of a recession.
The inversion of the 2-year and the 10-year yield have also caused worries. Investors saw the flashes of inverted yield curve in March for the first time since 2006.
For context, yield curves usually slope upwards, which tends to indicate a strong economy amid rising inflation and rising interest rates. In contrast, a flat yield curve represents less optimism from investors about economic growth and an inverted yield curve flags a recession is likely based on the historical figures.
Now a recession doesn’t appear immediately. JP Morgan analysts say “recessions don’t typically start ahead of the curve inverting, and the lead-lag could be very substantial, as long as 2 years… Further, over this timeframe, equities tended to beat bonds handsomely.” They added that the peak in equity markets historically takes place around a year after the inversion.
All this comes ahead of the highly anticipated US consumer price index (CPI) figures, which are expected to come in at 8.8 per cent year-over-year.
In the lead up to these figures, investors have been “buying the rumour” that inflation is set to move higher and hence equities have been sold off.
However, what would happen if the US CPI comes in higher than this?
Don’t be surprised if the US dollar continues to climb and gold continues to fall after hitting a 15-month low. Gold is currently at US$1,725, with the US$1,700 level not far away, and meanwhile we are seeing equities continue to pare back gains.
There has recently been a contraction of 20 per cent from the recent record highs, and the next part in a bear market is downgrades to consensus earnings estimates. The fact that we haven’t even started earnings season to see if there are any earnings revisions injects more uncertainty and volatility into the mix.
We will wait and see what lies ahead and if investors “sell the news”.