Stocks drop as falling U.S. yields, trade worries hit mood

Federal Reserve Chairman Jerome Powell speaks on a television as traders work on the floor of the New York Stock Exchange in New York

"The market decline in the US overnight and the flattening of the yield curve reflect that economic growth momentum is taking over as the primary concern for investors", Tai Hui, a strategist at J.P. Morgan Asset Management told clients. The longest-duration Treasury bond (meaning fixed-interest debt backed by the US government) is 30 years.

That the lower portion of the yield curve has inverted amid signs that the global economy is slowing is especially worrisome.

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In an "economic letter" published by the San Francisco office of the U.S. Federal Reserve (Fed), Michael D. Bauer and Thomas M. Mertens summarize the implications of an inversion succinctly: "Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve".

Here's what that does: Yields on short-term bonds rise above those of longer-term bonds, historically a signal that an economic slowdown is around the corner.

President Donald Trump has been railing against the Fed's ongoing policy of gradually raising interest rates, complaining that it's slowing US economic growth.

Wait, aren't lower interest rates a good thing?

In its view, those rate hikes are putting the brakes on borrowing and hiring, keeping inflation under control. And when is that fuel needed? In a flat yield curve, there's little difference between short-term yields and long-term yields.

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When did the yield curve invert?

On Monday, two- and five-year Treasury yields inverted, meaning the shorter-dated two-year money became more expensive than the later-maturing five-year.

No - and that's why this latest flip in yields may not augur recession.

Williams said the U.S. central bank should expect to continue raising interest rates "over the next year or so" even while it pays close attention to possible risks highlighted by financial markets. But that hasn't happened yet, noted Charlie Ripley, senior investment strategist for Allianz Investment Management. It was the first part of the Treasury yield curve to invert since the financial crisis, excluding very short-dated debt.

Not yet. The yield curve inversion reflects what investors believe at the moment, and historical patterns don't guarantee that an event will occur in the future. Shanghai markets fell 0.6 per cent, their losses limited by Chinese officials expressing confidence that a trade deal would be clinched on time.

Comments on Tuesday by New York Fed President John Williams about the path of interest rate hikes added to the uncertainty for investors.

"Investors are coming around to our downbeat view of the prospects for the US economy", analysts at Capital Economics wrote on Tuesday, arguing that there was no reason to regard this pending yield curve inversion as different from others.

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