Trade War Carnage Seen Forcing 3 Fed Rate Cuts in Big Policy Reversal

As the U.S.-China trade war continues to escalate, the bond market is anticipating a recession, with the yield curve on U.S. Treasury debt having inverted once again in 2019. The yield on 3-month T-Bills now exceeds that on 10-year T-Notes by the widest margin since 2007, the year in which that last U.S recession began, Bloomberg reports. Meanwhile, the Fed funds futures market is forecasting three interest rate cuts of 25 basis points each by the Federal Reserve between now and the end of 2020, on expectations that the central bank is now much more concerned about economic contraction than inflation.

“The overarching theme of slower global growth, inflation not hitting the mark of central bank targets, and the uncertainty of a protracted trade war are all contributing to that rally [in bond prices],” as Tano Pelosi, a portfolio manager at Australia-based asset management firm Antares Capital, which oversees the equivalent of $22 billion, told Bloomberg. “I can see U.S. 10-year yields heading toward 2% if the pressure from the trade war continues,” he added.

Details on yield curve inversions in 2019 are summarized in the table below.

Yield Curve Inverts Again in 2019

(Based on 3-Month vs. 10-Year Yields)

  • Previous inversion lasted from March 22 through March 28
  • Maximum spread during March inversion: 5 basis points
  • Latest inversion began on May 23
  • Spread at May 30 close: 16 basis points

Sources: U.S. Treasury Department (based on closing yields)

Significance for Investors

Yield curve inversions are commonly viewed as reliable predictors of upcoming recessions, and recessions often, but not always, spark bear markets in stocks. However, there is some debate about this leading indicator.

"Not every inversion has been followed by a recession," claims financial research firm Bespoke Investment Group, which also finds that the S&P 500 Index (SPX) historically has registered strong gains during the first 12 months after an inversion. Meanwhile, macro investment analytics firm Bianco Research says that inversions only become reliable recessionary predictors when they last for 10 days or more, per a report in Barron's.

Morgan Stanley has developed an "adjusted" yield curve that attempts to filter out the effects of quantitative easing (QE) and quantitative tightening (QT) by the Fed. This "adjusted" yield curve has been inverted since Dec. 2018, "suggesting recession risk is higher than normal," per the current Weekly Warm Up report from Morgan Stanley's U.S. equity strategy team led by Mike Wilson. "It looks like it may be bottoming which is typically the beginning of the end for the economic cycle," they add.

"The valuation and crowding concerns that caused us to worry about the possibility of a pullback back in April remain in place,” as Lori Calvasina, chief U.S. equity strategist at RBC Capital Markets, says in a note to clients quoted by Barron's. The May decline in stocks "has been mild compared to most of the periods of consolidation that occurred within the 2010, 2011, and 2016 rallies," she added. Morgan Stanley sees increased risk that the S&P 500 may fall to 2,400, or 13.9% below the May 30 close.

Looking Ahead

“History shows that countries in conflict have seen that such conflicts can easily slip beyond their control and become terrible wars that all parties, including the leaders who got their countries into them, deeply regretted,” Ray Dalio, the billionaire founder of hedge fund Bridgewater Associates wrote recently, as quoted by Bloomberg.

Take the Next Step to Invest
The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.