U.S. stocks dropped again today with the Standard & Poor’s 500 index closed down another 0.69% to 2783.03. U.S. Treasury bonds rallied with the price of the 10-yer bond up enough to push the yield down to 2.21% for a drop in yield of 26 basis points in the last month. That was enough to push the yield curve into deeply inverted territory with the yield on the three month Treasury bill at 2.36%, up 49 basis points–almost half of a percentage point–in the last year and the yield on the 2-year Treasury at 2.11% and the yield on the 5-year at 2.07%.
The good news in all this downward movement and volatility is that the odds are that the inversion in the yield curve DOESN’T signal, as it frequently does, that we’re in imminent danger of sliding into an economic recession.
Instead we’re seeing a test of the Powell Put as bond traders see whether or not the Federal Reserve will panic into announcing more or sooner interest rate cuts. That would put bond prices higher and yields even lower giving bond traders who are long Treasuries a very tidy profit.
The odds are that their speculation will pay off too.
Those bond traders who have put this trade on see financial markets that are likely to move down because they are nervous about a near-term Chinese retaliation for higher U.S. tariffs. The talk today was about a possible restriction of Chinese exports of rare earth minerals that are crucial to high technology products such as electric cars. China controls about 70% to 80% of the world’s supply of rare earth minsters.
They see a U.,S. President who would like to see lower interest rates from the Federal Reserve and who hasn’t been hesitant to bash the Fed in an effort to get the Fed to lower rates.
And they see a Federal Reserve that abruptly changed course in interest rates between the end of 2018 and the beginning of 2019 and a Federal Reserve chair who fumbled his commination of Fed policy. They’re betting that Fed chair Jerome Powell can be bullied into supporting the stock market through announcements that move up the next interest rate cut and open the Fed to more cuts in 2019.
The speculation in these bond market moves is that the Powell Put, the implicit promise that the Fed will move to lower rates if the market seems rocky, is in effect and will lead to yet lower interest rates. The market is currently pricing in three interest rate cuts, one in the fourth quarter of 2019 and then one in March 2020 and one in December 2020.
Frankly, I think that in the short run bond traders are likely to be right–I would not be surprised to see the yields on the 10-year Treasury drop even further towards 2%. This trade is risker than it was one month and 26 basis points ago, but I think there’s still money to be made on riding belief in the Power Put and buying a 5-year to 7-year Treasury ETF here. With a finger on the sell trigger when this trade snaps back in the other direction (even if only briefly.) The yield on the 10-year Treasury was last at 2% in late 2016.