Yield Curve Inversion Sends Stocks Careening Lower

Major Market Carnage As Yield Curve Inverts

As expected, stocks fell sharply after the 10-2 year yield spread inverted briefly. This was its first inversion since August 2007 which was 12 years ago. The Wednesday trading session became historic because the U.S. 30 year treasury yield fell to a record low and the German 10 year bund yield also hit a record low. The German bund now yields just -0.65% as it fell 4.5 basis points. It’s not impossible that America sees negative yields at some point in the next few years. The U.S. 10 year yield will hit a record low in the next recession and might even have a 0 handle.

It wasn’t a historic day for stocks as the Dow’s 3.05% decline was its 342nd biggest daily decline ever. However, there was carnage as the correction low was breached. The S&P 500 fell 2.93%, the Nasdaq fell 3.02%, and the Russell 2000 fell 2.85%. Large caps fell so much that they outdid the decline in the small caps. The S&P 500 fell about 4 points below the August 5th low. It is down 6.1% from its record closing high on July 26th. The correction is far from over. I can see stocks falling 10% before this is over. This decline in stocks and rally in treasuries amps up the importance of the Jackson Hole Symposium which is late next week.

VIX Explodes & Trump Reacts

It’s no surprise that the VIX rose sharply as it was up 26.14% which brought it to 22.1. That’s still not incredibly high for the size of the correction we’ve seen. Many traders probably don’t expect Wednesday’s action to continue for the next month. I certainly don’t as I don’t see this being the start of a bear market. The CNN fear and greed index fell 7 points to 20 which is extreme fear.

I expect Trump and the Fed to try to quell the volatility by suggesting a trade deal is coming soon and that more rate cuts are on the table. President Trump did something similar as he tweeted, “I know President Xi of China very well…I have ZERO doubt that if President Xi wants to quickly and humanely solve the Hong Kong problem, he can do it. Personal meeting?” It would be great for markets if the Hong Kong protests are resolved and America gets a trade deal. In that scenario, the S&P 500 could rally 5% quickly. I’m not predicting that to occur; I’m saying Trump will try to do what he can to end this correction.

Every Sector Falls Again

This has been a highly correlated market. On Monday every sector fell; on Tuesday every sector rose; on Wednesday every sector fell. There were a bunch of major sector declines on Wednesday as 6 fell over 3%. The worst ones were the financials and energy which fell 3.56% and 4.12%. With such a large decline in the financials, you’d think the Russell 2000 would have underperformed. The KBW regional bank ETF fell 3.2%. The good news for the banks is the yield curve is probably almost done flattening. There’s not much more it can go. The bad news is yields might not be done falling and the Fed definitely isn’t done cutting.

Historic Action In Treasuries

I can call the decline in treasury yields historic because the 30 year bond yield hit a record low. It hit a low of 2.01% which is over 7 basis points below the record low in July 2016. The yield curve is now fully flat. Expectations are for weak economic growth and weak inflation. On Wednesday morning, the 10-2 year yield curve finally inverted. Last year I projected it would invert by June of this year, so I was a couple months off.

Currently, both the 10 and 2 year yields are at 1.58%. It’s no surprise there was an inversion because expectations for future rate cuts didn’t increase, but the market became much more pessimistic on future growth. The Fed could normalize the curve like what usually occurs during recessions by cutting rates aggressively. However, core PCE inflation could hit 2% early next year. Plus, the economy doesn’t warrant such aggressive action as there is no recession yet. Specifically, there is just a 16.5% chance of a 50 basis point cut in September. There is about an equal chance of there being 2 and 3 more cuts this year.  

Meaning Of Yield Curve Inversion

Some say the yield curve inversion didn’t count because the close wasn’t inverted. Whether it counts probably doesn’t matter because there will probably be an inverted close sometime in the next few days anyway. The 10-2 year curve is the most popular curve followed by economists. Typically, when it inverts, it precedes recessions.

As you can see from the chart below, if the inversion precedes a recession by the average period, there will be a recession starting in September 2020. Usually stocks rally in the period after the inversion and before the recession. The yield curve was a hot topic late last year when the first part of the curve inverted. The curves are correlated which is why their recession prediction records are similar.

Cisco Does Badly In China

Cisco beat revenue and EPS estimates, but its stock cratered 7.71% after hours because of its weak guidance. That was on top of its 4% decline in regular trading hours on Wednesday. Specifically, EPS was 83 cents which beat estimates for 82 cents. Revenues were $13.43 billion which beat estimates for $13.38 billion. The quote that really scared investors was when the CEO stated, “We did see in July some slight early indications of some macro shifts that we didn’t see in the prior quarter.” The company saw “significant impact” from the trade war which hurt its Chinese business. The firm guided for 80-82 cents in Q1 2020 EPS which missed estimates for 83 cents. It projected 0% to 2% revenue growth. Estimates were for $13.4 billion in revenues which equates to 2.5% growth. Trade war news should impact Cisco stock significantly now that we know the negative impact tensions and tariffs can have. 

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