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Inverted Yield Curve: 3 Things to Know

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All eyes were on the spread between 2-year and 10-year Treasury yields Wednesday, which fell as low as -2 basis points (-0.02%).

The yield curve’s inversion — the drop of long-term yields to a level below that short-term yields — is typically seen as a signal of economic weakness, “although often with a relatively long lead,” according to LPL Financial Chief Investment Strategist John Lynch and the LPL Research team.

During the last five economic expansions, the U.S. economy peaked an average of 21 months after the spread between the 2-year and 10-year yields first turned negative, Lynch says.

What are his key thoughts on Wednesday’s inversion? 

1. Solid U.S. Economy

Though Lynch admits that the yield curve’s current shape has some strategists and investors “discouraged,” he says that LPL’s research team sees “few signs of danger ahead.” 

Data for the U.S. economy shows it is on “solid footing,” and corporate debt spreads have stayed “contained in this latest bout of volatility,” Lynch explains.

He adds that there are “few signs of excess in the financial system” today. 

It’s also worth recalling that yield curve inversions don’t spell total doom for the markets. “Historically, the S&P 500 Index has rallied an average of 22% from the first inversion to the eventual economic peak,” Lynch said.

“We’re not convinced that this yield curve inversion is a sign of imminent recession,” he explained. “The U.S. labor market is at full employment, healthy wage growth is fueling strong consumer activity, and corporate profits are at record levels.”

2. Global Matters 

Of course, there is a risk that a recession can become “a self-fulfilling” prophecy tied to market sentiment. 

But, LPL’s research team says, global fixed income is in a “curious” state right now, with Treasury yields “weighed down by intense global buying pressure amid ultra-low sovereign debt yields.”

Thus, the yield curve’s inversion “has been driven more by technical factors than domestic economic weakness,” according to the independent broker-dealer.

3. Overly Tight Policy 

As many market watchers shared Wednesday, this yield curve’s new shape sends a big signal to the Federal Reserve. 

“U.S. monetary policy is clearly still too tight,” Lynch said, “even after last month’s 25 basis point (0.25%) rate cut” due to trade uncertainty and a growing number of indicators showing a slowdown in global growth. 

“The Fed has promised flexibility, and we expect policymakers to enact one or two more cuts by the end of the year. Without an easier Fed, the U.S. dollar may stay elevated and global buying pressure will continue in Treasuries,” he explained.

What’s Next?

Stay tuned, the LPL Research team says. Don’t panic, and stay the course. 

“For now, we think the current U.S. economic expansion, now in its 11th year, has more room to run,” according to Lynch.

— Check out What’s Scarier Than the Inverted Yield Curve? on ThinkAdvisor.