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A Warning Sign From The Bond Market

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Last week, something might have happened that can be a sign of a potential market meltdown. The same thing occurred before five of the past six biggest market recessions. The yield on the benchmark 30-year U.S. Treasury Bond dipped below 2.5%. What this means is that the 30-year was earning less than the Federal Reserve’s short-term federal funds rate.

To realize how crazy the bond market is right now, is the fact that in this moment, it costs less to borrow money for a period of decades than to do the same for a period of just a few months. This phenomenon is known as the inverted yield curve, and it probably should worry us.

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In late May, another yield curve emerged that showed the difference between the rates for the 3-month US bond and 10-year Treasury. This was a yield curve watched very widely.

What worries people around the world is the fact that the inversion of the 30-year and federal funds rate is not a great indicator of financial stability. Indeed, the exact same took place just before most famous recessions in the modern history: the double-dip recessions of 1980-1982, the savings and loan crisis of the late 1980s, the Asian debt crisis of 1997, the bursting of the tech bubble in 2000 and the Great Recession of 2008.

The global macro analyst with Crescat Capital, Tavi Costa, believes we received a warning. He reminds us that the only time in the past four decades that the exact same happened and didn’t lead to a crisis was in 1986.

The recent yield curve inversion could be a sign that the stock market might soon hit a rough road. However, Costa adds that the shape of the curve is not the only sign that the stock market is at risk of a meltdown. He noted that the job market could be close to peak level because the rates of unemployment are low. Also, according to Costa, stock valuations are rich because the market remains near all-time highs.

“We are very late in the business cycle. It’s compelling to bet against stocks,” Costa said for CNN. “It’s a Goldilocks scenario with low inflation but that tends to happen towards a peak for the markets.”

Tavi Costa reminded that stock market fallbacks don’t have to be necessarily accompanied with economic downturns. However, the S&P 500, according to Costa, might be overvalued by as much as 40%. If their real value was to be balanced out in a short period of time, avoiding a recession might be hard to imagine.

However, other believe that the Fed will save the day with interest rate cuts, preventing a severe meltdown. The jobs report on Friday made it clear that the Fed won’t lower rates by a half a percentage point. Nonetheless, if the economy loses momentum, we could see more cuts later this year.

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The Fed is likely keeping close attention to the wage growth that showed signs of slowing down, after the US Manufacturing sector was hurt by the US trade war with China and several other nations.

Another expert in finances, Bill Stone, believes that the Fed will prevent a severe U.S. meltdown. Also, he reminds that the market can still go well for awhile even after the yield curve inversion. He adds, “The market expects about two net cuts in short-term rates over the next year and a half. Our view remains that the odds of a recession in 2019 remain low.”

Another finance expert, R.J. Gallo, the senior portfolio manager with Federated Investors, firmly agrees with Stone. He says that even though the yield curve is causing some alertness and fear, it still suggests that the market is highly confident that the Fed is going to have to ease. Gallo believes that everything will be soon resolved.

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