It is perhaps less important to study the link between yield curve inversion and recession than to focus on the implications of market reactions towards a perceived recession, and how that reaction will change the current climate of trade policy, monetary policy and consumer behaviour. 

Market sentiment turned extremely bearish last night as relief-rebound faded and the inversion of the US 10-year and 2-year treasury yield curve catalysed a new round of selloff as it was perceived to be a fairly reliable indicator for an upcoming economic recession. Over the past five recessions since 1978, the 10-year and 2-year yield inverted on average 20 months before recession knocked on the door.

Investors have learned many lessons and have tried to extrapolate past experience into future performance. This is dangerous as when people are foreseeing a major economic downturn to happen in the near future, they will start to curb spending and consumption; corporate earnings will fall, unemployment rate rises and credit markets will tighten up. The bearish outlook will reinforce itself into a negative feedback loop which might expedite the arrival of a recession. This is particularly true for the US market as US consumers are more sensitive to stock market performances.

Markets are now trying to price-in deteriorating fundamentals (Germany and China data), frustration from inconsistent trade policy that adds on economic uncertainty, and the fact that the tariffs delay is not helping to resolve any problems at all. Strong US CPI reading and the tariffs delay also leave the Fed less room to cut interest rates in the upcoming FOMC meeting at the end of September.

The US dollar rebounded for a second day, alongside other safe-havens such as Japanese yen, gold and treasuries. Asian equities today will face substantial selling pressure as fears of recession spill over across the globe.

Many people may ask, “Why is a treasury yield curve inversion an early indicator for a major economic downturn?” In my view, it can be explained in two perspectives. First, markets gets increasingly bearish on future inflation and growth outlook. This will drive down the long-term treasury yield curve, forcing the longer-term treasury yields (7-year, 10-year) to fall below the short-term yields (3-months, 6-months, 1-year and 2 year). Second, capital tends to flow into longer-term bond markets seeking for safety when the credit markets foresee higher risk ahead, while fleeing away from short-term bond markets. This twist in capital allocation will drive up long-term bond prices while depressing short-term bond prices, causing the yield curve to invert.

US SPX 500 - Cash

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