Right-side up again? The latest on the U.S. Treasury yield curve

On the latest edition of Market Week in Review, Senior Investment Strategist Paul Eitelman and Research Analyst Brian Yadao discussed the recent U.S. Treasury yield-curve inversion, progress in trade talks between the U.S. and China and the latest Brexit developments.

Yield curve temporarily un-inverts as 10-year yield ticks up

After inverting on March 22, the U.S. Treasury yield curve tentatively un-inverted on March 29, with the yield on the 10-year U.S. Treasury note rising slightly above the yield on the 3-month Treasury bill. This is welcome news for markets, Eitelman said, given that an inverted yield curve is typically one of the strongest predictors of an economic recession in the U.S. “Typically, once the yield curve inverts, the U.S. slips into a recession roughly a year later,” he explained.

Sometimes, the relationship between a yield-curve inversion and an economic downturn turns into a self-fulfilling prophecy, Eitelman said—if the curve stays inverted long enough. Why? “Banks make money on the difference between their ability to lend and the overnight deposit rates that they have to pay to customers—and as this spread narrows, their profitability diminishes as well,” he explained. This, in turn, typically leads to a lesser appetite for lending, Eitelman noted.

Trade-war watch: Progress made in the latest talks?

Shifting to trade, Eitelman said that progress appears to have been made in the latest round of trade negotiations between the U.S. and China. U.S. Treasury Secretary Steven Mnuchin, who traveled to Beijing March 28-29, noted that the talks were constructive, Eitelman stated. “While there’s no deal yet, the tone coming out of both countries sounds more upbeat, especially since the fourth quarter of last year,” he remarked.

Why? It looks like the U.S. may have potentially been somewhat rattled by December’s market selloff and decline in business confidence, both of which were likely due in part to trade uncertainty, Eitelman explained. A deal between both countries would probably lead to an uptick in business confidence levels, he said.

What’s next for Brexit after Theresa May’s latest setback?

On March 29, British lawmakers rejected UK Prime Minister Theresa’s May third attempt to get her Brexit deal passed. “So much for the third time being the charm,” Eitelman quipped, noting that the likely outcome of the failed deal is that the Brexit process will be delayed once more.

Eitelman and the team of Russell Investments strategists believe the two most likely scenarios for the UK going forward are a referendum vote on a soft Brexit deal, or a push toward a new general election. “Very simply, either of these two scenarios will take some time to develop and prepare for,” he said, adding that the UK’s current deadline to leave the EU—April 12—will likely get pushed back as a result.

“There really isn’t a clear or easy compromise in the works right now—and that’s both good news and bad news for markets,” Eitelman remarked. In the immediate sense, a Brexit delay is positive for markets because the likelihood of a cliff-edge, hard Brexit in the next few weeks is small. In the longer-term, however, the lack of a Brexit deal will hurt the UK economy, Eitelman said. “The latest setback in Brexit means that we’re likely to see a continued gradual slowing in business investment and activity in the UK,” he concluded.

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