Sharp Rally Ends the Week's Roller Coaster Ride

Market Moves

In what has become a volatile roller coaster ride of the past two weeks, stocks ended this week on a sharp rebound. This relief rally was driven by a bit of respite in the relentless drop of Treasury bond yields of late. On Friday, the 30-year Treasury yield bounced from Thursday's record lows, while the 10-year yield rebounded modestly from new three-year lows.

The past two weeks have seen a flurry of heightened volatility and sharp market moves as the ongoing U.S.-China trade war appeared to intensify, bond yields dropped to new lows, and the closely watched 10-year/2-year part of the yield curve inverted (when the 2-year yield rose above the 10-year) for the first time in well more than a decade. Since inverted yield curves have reliably signaled upcoming recessions in the past, severe economic concerns began to exacerbate worries about U.S.-China trade tensions this past week.

As we'll see on the chart of the 10-year and 2-year yields below, however, the yield curve was only briefly inverted. Of course, any inversion is concerning in itself, but a sustained inversion is even more troubling. It remains to be seen whether we will continue to see an inverted yield curve going forward.

In addition, both the U.S. and China seemed to back off from further escalating the trade war this past week. For its part, the U.S. announced that it would delay and/or cancel tariffs on certain goods imported from China. This was widely seen as a concession that helped boost the markets and ease tensions prior to the dreaded yield curve inversion.

The S&P 500 chart below shows the whipsaw price action in the past few weeks. The latter part of this past week has seen a clean bounce off new support around the 2,825 level, which matches the lows of the previous week. Looking ahead, this support level will be the price to watch as volatility potentially continues. If support holds, we could see a more pronounced rebound ahead. But if it breaks down on further trade and economic concerns, the next major area of support to the downside is around the 2,730 level.

Chart showing the performance of the S&P 500 Index

Treasury Yield Curve Emerges from Inversion

As noted above, the 10-year/2-year yield curve inverted briefly this past week. This is considered a relatively reliable signal of a future recession. As of Friday, however, this closely watched part of the yield curve is no longer inverted – that is, the 10-year yield is once again above the 2-year yield, as it usually is. Of course, this is not to say that the economy is out of the woods, but if it remains a one-time inversion, we could be seeing more confidence in the market and the economy on the part of investors.

Chart showing the performance of the 10-year vs. the 2-year Treasury yield

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Chinese Currency Remains Low Against Dollar

Prior to this past week's preoccupation with yield curves and recession, the primary market concern was that the trade war between the U.S. and China was intensifying and turning into a currency war. More specifically, the Chinese yuan currency fell below seven yuan to the U.S. dollar earlier this month, the lowest value it had been in more than a decade.

For the past many years, China had not allowed its currency to drop to such a low level. This was widely seen as a clear message from China to the U.S. that it is willing to fight a prolonged trade war on the currency front. One primary goal of a currency devaluation is to gain advantage for a traditionally export-driven economy like China. This has the effect of making Chinese goods less expensive and more competitive when selling and exporting to customers abroad. It's been a main driver of currency wars in the past.

Despite the easing of tensions this past week, the yuan remains below seven to the dollar, as shown on the chart of the U.S. dollar against the offshore (Hong Kong) Chinese yuan, otherwise known as USD/CNH. The chart clearly shows where the yuan dropped below seven (or the dollar went above seven yuan to one dollar). U.S.-China tensions are likely to remain elevated, at least on the currency front, as long as the yuan remains weaker than this key psychological level.

Chart showing the performance of the U.S. dollar vs. the Chinese yuan (USD/CNY)

The Bottom Line

Friday's stock rally is only the latest leg of a roller coaster ride that has rocked the markets for the past few weeks. Although the brisk buying activity to end the week was indeed encouraging, there are still many unknowns that have the potential to lead to significantly further volatility ahead. Watch developments in yields, trade, global economic indicators, the FOMC meeting, and the Jackson Hole Symposium in the week ahead for more indications of market direction going forward.

Stay safe and have a great weekend!

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