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!