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Yield Curve Inverts — The Fed Will Save Us From a Recession

Yield Curve Inverts — The Fed Will Save Us From a Recession

Article Highlights:

  • On Wednesday, the Dow dropped 800 points on an inverted yield curve sell-off.
  • For the past three decades, the Federal Reserve has rescued the markets.
  • One important tool shows us the probable path of interest rates for the future.

It was a quiet summer until a Trump tariff tweet in early August arrived like a turbulent thunderstorm on a sunny day. The market’s smooth sailing hit rough seas almost instantly.

Since hitting a record high on July 26, the S&P 500 Index has dropped around 5%. Of course, the market’s decline wasn’t in a straight line — it never is.

Volatility cuts both ways, like a double-edged sword. Over the past few weeks, the stock market has given us sharp rallies followed by steeper declines.

As a direct result of trade policy uncertainty, the yield curve inverted on Wednesday. That means the yield on the U.S. 10-year Treasury dipped below the yield on the two- year Treasury.

 

An inverted yield curve has preceded the last seven recessions. And, like Lois Lane in the Superman comics, investors are left openly wondering: “Who will save us now?”

An inverted yield curve impacts banks, as they borrow at the short end and lend at the long end, typically capturing the positive spread.

When the curve is inverted, this moneymaking spread turns negative, and that causes a slowdown in lending. Without lending, the economy can’t grow.

An inverted yield curve has preceded the last seven recessions.

It doesn’t mean a recession is around the corner, however. According to Bank of America Merrill Lynch, since 1956, it’s taken an average of 15 months for a recession to hit after an inversion of the two-year/10-year spread occurred.

But investors don’t care about nuance. On Wednesday, the Dow Jones Industrial Average dropped 800 points on an inverted yield curve sell-off.

That was enough to send my favorite panic indicator, the CBOE VIX Volatility Index (VVIX), up to 116, the highest reading since May.

And, like Lois Lane in the Superman comics, investors are left openly wondering: “Who will save us now?”

The Fed Put

For the past three decades, the Federal Reserve rode to the rescue in times of global uncertainty.

In the Alan Greenspan era from 1987 to 2000, the Fed would ease interest rates when the market dropped. This became known as the Greenspan Put.

Fed Chairs Ben Bernanke and Janet Yellen adopted similar policies of easing rates, and it became known as the Fed Put.

The term “put” refers to a put option, which is a contract that gives the owner downside protection if an asset drops below a specified price.

The Fed Put insinuates that stock market buyers are protected from drops because the Fed has their back and will do what’s necessary to prop up the stock market.

The Probable Path of Interest Rates

When the markets turn volatile, I turn to the FedWatch Tool on the Chicago Mercantile Exchange’s website to see when the Fed Put is in play. The Fed funds futures give me the probable path of interest rates for the future.

Check out this video where I explain how I use Fed funds futures prices to see how rate expectations have changed in the past few weeks:

Regards,

Ian King

Editor, Automatic Fortunes

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