What the inversion of the U.S. Treasury yield curve might mean for markets

On the latest edition of Market Week in Review, Chief Investment Strategist Erik Ristuben and Rob Cittadini, Director, Americas institutional, discussed recent Brexit developments as well as the inversion of the U.S. Treasury yield curve.

Tough road ahead for UK even as Brexit extension granted

After Parliament rejected UK Prime Minister Theresa May’s Brexit deal twice, May sought for and received an extension in the Brexit process from European Union (EU) officials on the 21st of March. "The extension is an interesting one," Ristuben remarked, explaining that the EU will push out the Brexit deadline to the 22nd of May, provided that May can secure parliamentary approval of her plan by the end of next week.

"If May’s plan gets turned down by Parliament again — which is what many political analysts expect — then the UK has until the 12th of April to submit a new Brexit plan," Ristuben said. This is because the 12th of April is the day when the UK has to announce whether or not it’ll be participating in the European elections in May, he explained.

The Brexit extension means there’s still a possibility that the UK could exit the EU without a deal in place, Ristuben said. "If May’s current plan is rejected by lawmakers and the UK doesn’t put together a new plan by the mid-April deadline, then the UK would crash out of the EU on the 12th of April," he said.

The inversion of the yield curve: A warning sign for the economy?

The U.S. Treasury yield curve inverted on the 22nd of March, Ristuben said, with the yield on the 3-month Treasury bill now higher than the yield on the 10-year Treasury note for the first time since 2007. "This is a troubling sign, because such an inversion has occurred prior to each of the last seven U.S. recessions," he stated, "and it’s a major indication that the bond market is concerned about economic growth going forward as well as risks to the economy and markets."

While equity markets have rallied significantly from their Christmas Eve lows, the bond market has not been buying the optimism, Ristuben noted. "Yields on Treasury notes have been falling since the start of the year, and that’s usually a fairly bearish sign," he explained, adding that the yield curve had also been flattening over the past few months.

"The inversion of the yield curve is a pretty serious shot across the bow of the bond market," Ristuben remarked. The likely trigger for the inversion, he noted, was the U.S. Federal Reserve (the Fed)’s dovish shift in monetary policy, which was further stressed by Chair Jerome Powell at the conclusion of the central bank’s policy meeting on the 19th-20th of March. "With the median FOMC (Federal Open Market Committee) member now anticipating no interest-rate increases in 2019, the U.S. bond market is actually pricing in a 60% probability of a rate cut by the end of the year — and the Fed only lowers rates when it’s seriously concerned about economic growth," Ristuben stated.

What’s unusual about this yield curve inversion, he said, is that typically the spread between the 10-year and 2-year Treasury yield inverts first — rather than the spread between the 10-year and 3-month yield. "The difference between the 10-year and the 3-month is the bigger deal," he said, "so make no mistake: this is a sign that the market needs to take very seriously."

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.