An energy trader points to a graph on a desktop computer screen in the offices of an electric utility company. (Photographer: Krisztian Bocsi/Bloomberg)

Tumbling Stocks Show You Can’t Ignore the ‘Harbinger of Doom’

(Bloomberg) -- U.S. stocks suffered the biggest rout in almost two months Tuesday, and among the primary culprits is a shift in how bond investors view risks to the economy.

Known as the inversion of the yield curve, where short-term interest rates climb above longer-dated ones, the signal is considered among the best predictors of a future slowdown. One relationship, the spread between three- and five-year Treasury yields turned negative for the first time in more than a decade Monday.

“There are signs of slowing global growth,” said Kim Forrest, a senior portfolio manager at Fort Pitt Capital Group. “But what does that mean? Is it a recession or a slowdown? That combined with the harbinger of doom -- the inverted yield curve -- I’m paying attention to it.”

Here’s how it affects other markets:

Tumbling Stocks Show You Can’t Ignore the ‘Harbinger of Doom’

Stocks

An inversion of the yield curve is a bad omen for equities, according to Bank of America Corp. strategists. In a note to clients this week, Mary Ann Bartels and Andrew Shields recommended investors reduce stock holdings as the S&P 500 risks falling into a mild bear market next year.

The worry is not so much the curve inversion itself, but the factors driving it.

“Policy tightening by the Federal Reserve, concerns over trade with China and slowing corporate profits -- with earnings estimate revisions moving negative -- are not good ingredients for stocks or bonds as we enter 2019,” they wrote.

Increased volatility and a short-lived “baby bear” market are all in the cards, they said.

Dollar

Deutsche Bank AG reckons there’s a harbinger for the greenback in the curve, but rather than inversion, the key is whether it’s concave (bullish) or convex (bearish).

“The crucial question,” wrote London-based strategist Robin Winkler, “is whether the U.S. rates curve retains enough curvature relative to other currencies to offset the drag from its inverted slope.”

Tumbling Stocks Show You Can’t Ignore the ‘Harbinger of Doom’

The dollar’s strength can been seen in its “steep and concave, hump-shaped curve relative to the rest of the world,” according to Deutsche Bank. That hump may now be about to collapse under a less-hawkish Federal Reserve, according to the strategist.

“The recent dovish turn from the Fed poses downside risks to the dollar’s curvature support,” he wrote in a recent note. “In our view, curvature is likely to decline.”

The warning comes as the greenback slipped and then pared losses as investors assessed the trade truce between the U.S. and China.

Tumbling Stocks Show You Can’t Ignore the ‘Harbinger of Doom’

Emerging Markets

Somewhat counter-intuitively, for developing-nation assets the inversion could prove a bullish signal as Marcus Ashworth wrote for Bloomberg Opinion. Should the Fed become uncomfortable with shorter-maturity bonds yielding more -- an unnatural state of affairs -- it could be persuaded to ease off tightening.

This would be another potential headwind to the dollar, and relieve stress in beaten up emerging assets.

“This is a goldilocks environment for emerging markets -- a dovish Fed is containing rates and the dollar is poised for weakness yet growth expectations have remained steady,” said Frances Donald, head of macro strategy at Manulife Asset Management in Toronto.

Credit

When the Treasury curve inverts, high-grade companies find it harder to access long-term financing. Investors generally require more compensation as the maturity of debt increases, but with an inversion they get the opposite.

This forces issuers to print shorter-dated deals that come due when rates may be higher, boosting the companies’ marginal cost of capital.

Still, the consensus seems to be that the inversion needs to be seen in more meaningful spreads before it has a major impact across assets.

“I don’t think the 3s5s inversion alone will impact performance across asset class in the near term,” said John Iborg, portfolio manager at QS Investors. “More flattening or an inversion in 2s10s and 10s30s will grab people’s attention more and will matter more to market participants and expected returns.”

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