If you ask most people who watch the news, why stocks fell Tuesday (and Thursday, thus far), it’s likely that 95% will say the President’s “Tariff-man” Tweet. And they would be dead wrong. It may have been a factor, but only a secondary one. (I believe his comments were ill-advised). Here’s why his comments did not cause the selloff.
Fact: The Tweet occurred several days before last Tuesday’s decline.
The actual reason stocks fell was that the yield on the 5-year U.S. Treasury fell “slightly” below the yield on the 2-year Treasury. How do I know this was the cause? Because the Dow was only slightly down (close to flat) on Tuesday until around 1:00. Then, the 5-year rate dipped below the 2-year rate, and stocks began to slide. Why would this cause a selloff? Investors perceive a slowdown in the economy when the yield curve inverts. More on that in a moment.
Fact: The bond market is a better indicator of economic strength or weakness than the stock market.
Fact: The stock market overreacts to the upside AND to the downside.
Fact: The Federal Reserve tends to raise rates (i.e. short-term rates) 2-3 times too many (think…Tech Bubble).
The Yield Curve and Recessions
Many times, when the yield curve inverts (the 30-year or 10-year rate is lower than the 3-month rate), a recession follows. This was the case more often before 1980. Not so much since then. Sometimes an inversion occurs without a recession. I have studied this issue extensively (curious as I am) and wrote a three-part analysis for ThinkAdvisor in May.
Tuesday’s Stock Selloff…
Tuesday, when the 5-year rate fell below the 2-year rate, investors got nervous and sold stocks. A lot of money went to Treasuries, especially the 5-year and 10-year Treasury. That is why their yield fell!
Fact: When the price of a bond rises, its yield (%) falls, and vice versa. In other words, greater demand pushes a bond’s price higher and its yield lower. Therefore, as money flowed into these safe-havens, their price rose, and their yield fell. That’s why the 5-year dipped below the 2-year and that’s what caused the selloff.
During the 1990s, Fed Chair Alan Greenspan was asked the following question:
If you could look at only one indicator for the health of the U.S. economy, what would it be?
Greenspan responded, “The yield on the 10-Year Treasury.”
Admittedly, I didn’t fully understand it at that time, but came to understand it clearly a few years later. The yield on the 10-year Treasury is closely tied to the 30-year mortgage rate (i.e. many people do not hold a 30-year mortgage for 30 years–they refinance).
What’s to Come?
Because the U.S. economy IS doing well, I don’t expect this selloff to last for long. While I cannot say this with certainty (ex: if the 5-year remains lower than the 2-year, etc.), there are too many positives in the American economy for the economy to weaken…..yet. Maybe after the first of the year, or after the first quarter, but not now.
Check out part 1 of my recession analysis published on thinkadvisor.com (a site for advisors). This will provide education on the yield curve and recessions from the early 1960s. Good reading!