The increasing probability that the U.S.-China trade and financial war will be a permanent feature of the global economic landscape is the catalyst for the inversion of the two-year-10-year Treasury yield curve on Wednesday. This inversion of that portion of the curve is the first since June 2007, which marked the start of the Great Recession. Equally important, however, is the decline to negative inflation-adjusted yields in the front end of the curve. This means that on an inflation-adjusted basis the 10-year Treasury is yielding negative 20 basis points, which effectively means that long-term investors are paying a 20 basis-point premium to the U.S. Government for the privilege of holding Treasuries.
While the U.S. economy is not yet in recession–we would need to see an increase in first-time jobless claims, monthly job gains below 100,000 on a sustained basis (which would send the unemployment rate higher) and a move below 50 in the ISM Services Sector survey to indicate a recession has begun–the inversion of the yield curve and the appearance of real negative yields clearly indicates that the business cycle has entered its final stages and recession risks are elevated. In our estimation, there would need to be a clear signal of a permanent cessation of trade hostilities between Washington and Beijing to turn around risk and business sentiment.
Real negative yields are now a long-term feature of the U.S. financial landscape. One typically sees real negative yields late in the business cycles and sometimes used as a policy tool by the central bank to bolster economic activity during economic downturns. Over time, this should act to boost demand for housing and provide support for the beleaguered U.S. auto sector.
Given the more than $15 trillion in negative yielding debt on a global basis, which accounts for approximately 25 percent of all global fixed income investment, the market will slowly adapt to lower rates, low inflation and the coming of negative nominal rates if the economy become ensnared in a much longer and deeper downturn linked to the trade and financial conflict.
