Pessimism Reigns

By Nicholas Jasinski  |  Tuesday, August 30

Warning Sign. Markets remain restless, with investors extending a streak of late-summer volatility as the fallout from Friday's repricing of Federal Reserve policy expectations continued. In short, markets now see higher interest rates and slower economic growth ahead than they did a short while ago.

The yield on the 2-year U.S. Treasury note settled at 3.47% today, its highest level since late 2007. That reflects investors' view of the near-term path of Fed policy—the security matures in two years, after all, and its yield is closely tied to expectations of benchmark interest rates in that period. 

Futures markets now have the fed-funds rate peaking at a target range of 3.75% to 4.00% in the first half of next year, similar to the median prediction by Fed officials in their June Summary of Economic Projections.

The 10-year U.S. Treasury note yield, meanwhile, held about flat today, near 3.11%. That's down almost 0.38 percentage point since mid-June and reflects investors' forecasts for interest rates over the coming decade. The fact that it's below the 2-year yield means that markets are pricing in lower rates over the longer term. Essentially, investors expect to see rates rise, then fall, over the coming years.

It's also a warning sign that a recession is potentially on the horizon.

Investors tend to demand higher interest to lend for longer periods because there's inherently more inflation and interest-rate uncertainty over the long term than in the short term. When short-term Treasury yields exceed longer-term yields, the U.S. Treasury yield curve—the slope plotting interest rates on Treasuries of different maturities—becomes inverted. That's a sign that investors see more risk on the near horizon and demand more compensation. It's also reflective of the Fed's recent and coming moves, which are to intentionally slow down the U.S. economy to damp sky-high inflation.

In fact, every U.S. recession since World War II has been preceded by an inverted yield curve. The last two times it inverted before this year was in 2019 and 2007. We all know what came soon after each of those inversions.

Markets seem to have a greater appreciation of the Fed's determination to stomp out inflation, and the economic pain that must be endured to get there. That growing pessimism has further inverted the yield curve and knocked stocks since Friday.

"One other factor to watch is the spread between the 3-month and 10-year," wrote Barron's Lawrence Strauss today. "That spread isn’t inverted yet, though it has been flattening for months. If it inverts, it would be a sign that the bond market is all but 100% certain a recession is imminent."

The Dow Jones Industrial Average lost 1% today, while the S&P 500 and Nasdaq Composite both slid about 1.1%. It was the third-consecutive loss for all three indexes.

DJIA: -0.96% to 31,790.87
S&P 500: -1.10% to 3,986.16
Nasdaq: -1.12% to 11,883.14

The Hot Stock: EPAM Systems +2.1%
The Biggest Loser: CF Industries -6.5%  

Best Sector: Financials -0.5%
Worst Sector: Energy -3.4%