The stock market took a dive on August 14th as the 2-Year and 10-Year Treasury Notes inverted, if for only a brief few minutes. The S&P 500 quickly sold off by 2.5%. Why all of the panic?
Since 1956, each 2/10 yield curve inversion has proceeded every recession, according to Bank of America Merrill Lynch. The average recession started 15 months after inversion. Does this brief inversion matter? Only time will tell. While earnings are slowing down, the U.S. economy is still slowly growing. The BEA reported that 2019 Q1 real GDP grew at 3.1% while Q2 grew at 2.1%. Yes - slowing but definitely in recession territory.
Looking closer at the 2/10 yield spread, let's understand what is going on there. When the 10-year note yield goes below the 2-year note yield, an inversion occurs. For example, if the 10y is trading at 1.59% and the 2yr at 1.57%, all is well, and there is no inversion. However, if the 10y trades below 1.57%, inversion occurs.
The effect of an inverted yield curve on banks is negative. Banks pay short-term interest rates for deposits (i.e., 2y interest rates) and lend at longer rates (i.e., 10y rate). The spread between the 2/10, in this case, is the bank's profit. If that spread goes to zero or inverts so it is negative, the bank is not able to make money on the above 2/10 spread. This causes capital to cease up as banks are not willing to lend money anymore. In a worst-case scenario, the end result is that businesses are denied capital, profits begin to shrink, people get laid off, and GDP contracts. Ultimately, we end up in a recession.
Because the 2/10 spread has been a good predictor of recessions in the past doesn't mean this will always be true. It will work until it doesn't. But the 2/10 inversion is certainly something to be wary of.