Next stock market crash: How yield curve inversion could accelerate it - Josh Loe

Next stock market crash: How yield curve inversion could accelerate it

There’s an old saying that when it rains, it pours. And unfortunately for investors everywhere, that rang true in the stock market on Friday.

It was ultimately a perfect storm of conditions. Even though US shares closed at a five-month high on Thursday, repeated signs of an economic slowdown in the prior weeks left them in a vulnerable position.

Then, as US investors slept, weak European manufacturing data sent the yield on 10-year German government bonds into negative territory for the first time in more than two years. European shares traded sharply lower in response.

An eerily similar scenario played out in the US not long thereafter. After a report showing manufacturing activity slumped to its lowest in two years, Treasurys tumbled, leading to a dreaded yield-curve inversion that hadn’t occurred since 2007.

That stoked already-simmering fears of a possible economic recession, and what followed was a weak and uncertain trading session.

All the while, as those forces played out on the surface, investors were showing their displeasure in another way for a solid week. According to data compiled by Bank of America Merrill Lynch, fund managers pulled loads of money of out stocks even before Friday’s sell-off.

It amounted to a vicious trifecta that handed US stocks their biggest drop in two months. And at a time when the market’s biggest tech stocks are under regulatory scrutiny and there are relatively few corporate earnings reports to move the dial, there doesn’t seem to be much relief on the horizon.

Even the Federal Reserve— which some experts point to as supporting the stock market with a newly accommodative monetary policy — will be powerless to help the market if the economy keeps trending lower, one expert says.

“The Fed can’t be dovish enough to support US equity markets given the acceleration in the global growth slowdown and eventual US slowdown,” Peter Cecchini, the global chief market strategist at Cantor Fitzgerald, wrote in a recent client note.

With all of that established, here’s a deeper dive on the three-pronged monster that attacked stocks on Friday. After all, the more you know about each component, the better-equipped you’ll be to navigate any patch of extended weakness.

1) Yield curve inversion

On Friday, the spread between the 3- and 10-month US Treasurys fell into negative territory — or “inverted” — for the first time since 2007. This relationship is considered one of the foremost indicators of a recession, since an inversion has preceded every major economic contraction since 1975.

2) German yields turn negative

Friday also featured another feat of the yield variety: German 10-year government bond yields dropped into negative territory for the first time since October 2016.

The catalyst was weaker-than-expected manufacturing data from Europe, with Germany and France identified as the two nations under the most pressure. Germany — which relies heavily on exports — is being hurt to an outsized degree because of its reliance on China, which is also slowing.

The negative German yield also has significance for US yields, which will be pushed lower as investors flee Europe and pile into Treasurys.

3) Major equity outflows

BAML data shows investors pulled a “massive” $20.7 billion from equity funds during the week ended March 21. There was “simply no love for stocks,” wrote chief investment strategist Michael Hartnett.

That outflow isn’t particularly surprising, however, when you consider that fund managers surveyed by BAML are holding the smallest amount of stock exposure since September 2016. In fact, their allocation is almost in negative territory — something that’s happened just once in the past six years.

This development can be seen in the chart below:

Bank of America Merrill Lynch

Source link