Stocks got crushed on Tuesday, starting off a holiday-shortened week in the U.S. with losses across the board.
The Dow was the big loser among the major averages, dropping 391 points, or 1.6%. The benchmark S&P 500 fell 31 points, or 1.1%, while the tech-heavy Nasdaq saw the lightest losses, dropping 37 points, or 0.5%.
Treasury yields rallied on Tuesday as the 10-year yield absolutely ripped higher to settle around 2.77%. This is a roughly 30 basis point swing from levels seen less than two weeks ago.
The proximate cause of market turmoil on Tuesday was political instability in Italy, leading to potential elections later this summer and stoking investor fears the third-largest economy in the eurozone could potentially leave the currency bloc.
Subsequent reports suggested that trade tensions between the U.S. and China are not quite as close to being resolved as had been suggested pressured markets near mid-morning. Additionally, the drop in yields pressured bank stocks all day as the XLF ETF that tracks the sector declined 3.5% on Tuesday.
So, even with a holiday-shortened week, there’s a lot going on for markets to digest.
On Wednesday, investors will get three key pieces of U.S. economic data as private payrolls from ADP and a second read on U.S. GDP growth in the first quarter will be released in the morning. Expectations are the GDP number will show the economy grew at an annualized rate of 2.3% in the first three months of the year.
And then in the afternoon the Federal Reserve’s latest Beige Book report will be released. The Beige Book is a collection of economic anecdotes collected by Fed officials across the country and helps form the basis of the economic discussion that will be had at the Fed meeting in two weeks’ time.
The yield curve
If you’ve heard it once, you’ve heard it a million times — a flattening yield curve signals bad things for economic growth.
Over the last month, the yield curve as defined by the spread between the two-year and ten-year Treasury note has been right around its flattest level in 11 years. As of Tuesday’s close, the spread was 47 basis points, or 0.47%.
Ahead of recessions, the yield curve tends to invert as rising interest rates press short-term yields above long-term yields, which may also be tamped down by investor pessimism about future economic growth.
Economists and market commentators are split on whether the current state of the yield curve is good or bad. Larry Fink, CEO of BlackRock (BLK), and Fed chair Jerome Powell aren’t too worried. Other Fed officials are not so sure.
In a note to clients on Tuesday, Joe LaVorgna, chief economist for the Americas at Natixis, sounded the alarm on the current state of affairs along the U.S. Treasury curve.
“The Treasury yield curve is sending an ominous message about future economic activity,” LaVorgna said. “Over the last couple of decades, the Treasury yield curve has led the peaks and troughs in real GDP growth by approximately eight quarter,” adding that, “when the curve begins flattening it continues to flatten until there is a recession. Critically, the yield curve seldom if ever meaningfully re-steepens late in an economic cycle.” (Emphasis ours.)
To combat this flattening yield curve and what LaVorgna sees as a market dynamic “consistent with a sharp slowdown in real GDP growth sometime in 2020,” he argues that Fed officials should be less aggressive in raising interest rates.
Currently, the Fed Funds rate is around 1.7%. LaVorgna estimates the long-run neutral rate — more on that here — is around 2%. This means there is basically one or two rate hikes left for the Fed to do until they should do nothing. For a while. Or, at least, until inflation really starts accelerating.
The Fed’s own forecasts suggest that through the end of the decade we’ll get another six or seven rate hikes until the Fed Funds rate is closer to 3%. In two weeks, we’ll get a new set of economic projections and interest rate forecasts from the Fed. Markets also expect the central bank will raise the target range for the Fed Funds rate by another 25 basis points.
The big rally seen in Treasuries on Tuesday — the largest since Brexit in 2016 — also saw market pricing for future rate hikes drop to just two through the end of the decade. And if longer-term Treasury bonds continue to catch a bid amid investor worries but the Fed’s rate hike cycle continues as forecast, then inversion appears likely sooner rather than later.
Myles Udland is a writer at Yahoo Finance. Follow him on Twitter @MylesUdland