President Trump called it a “little disturbance.”
Another administration official referred to it as a “detox period.”
Massive cuts to government spending – along with uncertainty around tariffs and growing trade wars – are disrupting the economy.
The Federal Reserve’s Atlanta district recently showed over 2% annualized GDP growth for the first quarter. That estimate now stands at -2.4%.
That would be the first decline in economic growth since the second quarter of 2022.
Other indicators suggest caution as well. The most recent payrolls report missed estimates while unemployment ticked higher to 4.1%.
The uncertainty is helping drive the S&P 500 into correction territory. On an intraday basis, the index fell 10% from its February peak.
And a new warning sign could mean more pain for the economy and the stock market ahead…
Falling Interest Rates
The Fed controls short-term interest rates. But other forces drive longer-term interest rates, such as the outlook for inflation and the economy.
When inflation expectations move higher and the economic outlook is strong, long-term Treasury yields tend to move higher.
Yet when the Fed cut short-term rates for the first time back in September, the 10-year Treasury rate still jumped higher.
From mid-September to mid-January, the 10-year Treasury yield rose from 3.62% to 4.80%, as you can see below.
Lingering inflation and a strong labor market helped send the 10-year higher despite the Fed’s rate cuts.
But since January 13, the situation has changed. The 10-year yield has dropped to 4.28%.
Questions about the growth outlook are now leading to a pullback in longer-term Treasury yields.
And that’s triggering a signal that the economic pain might only be starting…
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Watch the Yield Curve
The “yield curve” compares where short-term rates are trading relative to long-term rates.
Normally, longer-term rates are higher than shorter-term ones. After all, people who buy bonds, for example, need more compensation in exchange for locking up their money for a longer period.
So the yield curve is usually in positive territory.
But sometimes, the yield curve flips upside down and becomes inverted by moving below zero.
This usually happens when the Fed holds short-term rates at elevated levels. It can also happen if long-term rates come down due to concerns about the growth outlook.
Historically, an inverted yield curve has been a reliable warning signal of a coming recession.
Look at the chart below:
The line shows the 10-year Treasury yield minus the 3-month yield going back to 1985.
When the line has dropped below zero, a recession usually follows shortly after (the shaded areas on the chart).
In recent years, the yield curve has received a lot of attention. It went inverted at the end of 2022 and stayed there for two years without a recession.
Then the yield curve finally rose back above zero in December.
Yet suddenly, the yield curve has dropped below zero yet again. And no one is talking about it… or what it portends.
The Fed is still holding short-term rates near the highest levels since heading into 2008’s financial crisis… and uncertainty is dragging long-term rates lower.
The conditions for a recession are still there and haven’t gone away. And the recent uncertainty is heightening the chances.
This month, Goldman Sachs bumped up its chance of recession from 15% to 20% over the next 12 months. JP Morgan Chase economists have raised their estimates from a 30% to a 40% chance.
That means it’s time to put this recession signal back on your radar.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict