The Yield Curve: Jul 16, 2018

Futures are flat at the moment, despite sizeable moves in WTI (-2.14%) and RBOB (-2.62%) and a sharp pop in rates.  While we wait for oil and gas to reach our downside targets, I thought it would be a good time to revisit our yield curve charts.

Many of you will remember this chart from May 3 [see: The Yield Curve – An Update.]

At the time, I considered it one of the most important charts to keep an eye on.  Previous bounces off the TL connecting those previous lows correlated strongly with the 2000 and 2007 crashes.

With the 10s2s spread approaching negative territory, we wondered whether or not we’d see a repeat.  Here’s where things stand now.  Note that the curve has not only reached the TL, but has dropped beneath it.

As we’ve discussed many times, a flattening curve is typically positive for stocks.  It’s those sharp spikes higher that do most of the damage.

Back in January [see: China – It’s Not Me, It’s You] I pegged the upside for TNX at 28.56.  I considered the rise above it February an overshoot, convinced that it wouldn’t last. I was partially right. As expected, the pop up to 31.15 in mid-May didn’t last.  But, TNX has clung stubbornly to our target range.  The purple TL from Sep 7 held until May 25, at whit point TNX broke down and tagged our initial downside target — but, not further.In fact, it experienced a strong backtest that lasted through mid-June, and is still hanging around 28.56.

One might wonder why, with the Fed so involved in “managing” interest rates, TNX has been so hesitant to reverse.  That’s where the yield curve comes in (and, a little currency manipulation.)

With the short end of the curve rising in conjunction with the FOMC’s rate hikes, a bigger drop in the 10Y could easily produce an inverted curve — generally considered a precursor to a recession.

10s2s is presently positive by only 25 bps.  So, there is precious little room for the 10Y to drop — at least until the Fed stops hiking rates.  Glass-half-full analysts see rate hikes as appropriate, given the economy’s strong performance.  Cynics see them as a maneuver to create more headroom for the next time the Fed has to step in and save the markets.

Whichever the case may be, the Fed will prevent an inversion for as long as possible.  If/when one does occur, they will be even more cautious about allowing it to unwind rapidly.

If things go according to plan, oil and gas will drop just enough to dissipate the recent inflation pressure — allowing DXY to settle lower along with 10s and 2s.  If they don’t, things could get ugly.

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