Yield curve inversion and the SP500

The relief rally in stocks that followed last week’s dovish FOMC meeting proved short lived as trader attention turned to the interest rate market where the spread between U.S. short-term and long-term rates inverted on Friday for the first time since 2007. Specifically, the yield on U.S. 10-year Treasury yields fell to 2.42%, just below the 2.43% yield on 3-month Treasury bills.

Overnight, U.S. 10-year Treasury yields continued to fall, and the yield curve inverted further, despite the March German IFO number beating expectations. The headline IFO business climate number came in at 99.6 verse expectations of 98.5, while the more important forward-looking expectations measure printed at 95.6 vs market expectations of 94.0. Ironically, the stronger than expected IFO number was in stark contrast with last Friday’s much weaker than expected European manufacturing PMI, highlighted as one of the key catalysts behind Friday’s yield curve inversion in the first place!!

Possibly paralysed by the contradictory European data, the market appears to have taken notice of an overnight speech by Federal Reserve member and voter Charles Evans. Evans stating "at the moment, the risks from the downside scenarios loom larger than those from the upside ones”. Markets are now pricing a full 25bp rate cut by the Federal Reserve by the end of 2019.

So, aren’t lower interest rates good for equities and why all the fuss about the yield curve?

Yes, lower interest rates are usually good for equities. For a timely reminder of this, look no further than the rally in the ASX200 that occurred back in mid to late February, following the call for two rate cuts in Australia this year, from the well-respected Chief Economist of a local bank.

In the U.S., there is some suspicion about why after performing its biggest policy backflip in twenty years, the Federal Reserve then needed to go out of its way at last week’s FOMC meeting to emphasize even more caution and patience. Is the Fed seeing evidence of a slow-down or even a recession that is not yet evident in the data?

The answer to the second part of the question is the inversion of the 3 month / 10 year yield curve is the Fed’s preferred measure and does have a strong track record of predicting recessions. While the chart below does extend back beyond 1988, it is true the yield curve was inverted immediately before the four recessions beginning 1969, 1973, 1980 and 1981. Likewise, and as the chart displays it warned of the 1990, 2001 and 2007 recessions.

Considering the information above it is a good idea for equities traders to keep an eye on further developments in interest rate markets and the yield curve. As always though we suggest allowing price action to have the final say.

Technically, the S&P500 appears to have completed a 5 wave advance from the December 2316.75 low to last week’s 2858.75 high. There is bearish RSI divergence viewed at the 2858.75 high as well as a bearish weekly candle. Following the overnight close below the uptrend support at 2810 there are now more than enough reasons to move to a more neutral bias.

However, to turn short term bearish a daily close below the lower band of horizontal support 2800/2790 is required in anticipation of a retreat initially back towards the recent 2726.50 low, and possibly as deep as 2650. Conversely, should the S&P500 hold above the 2800/90 support on a closing basis, the uptrend remains in play.

Source Tradingview. The figures stated are as of the 26^th of March 2019. Past performance is not a reliable indicator of future performance.  This report does not contain and is not to be taken as containing any financial product advice or financial product recommendation

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