Stock markets were shaken on Tuesday as doubts grew over the U.S.-China trade truce and the Treasury yield curve flattened sharply, a development that can sometimes be an indicator of future recession.
On Tuesday, the Dow Jones Industrial Average closed down 6.71% from its peak in early October, while the S&P 500 index closed down 7.87% from its peak in mid-September. Both are nearing market correction territory, generally considered to be a decline of more than 10% (but less than 20%). U.S. stock and bond markets will be closed on Wednesday for the funeral of former President George H.W. Bush.
Stocks had gained on Monday after it appeared that the U.S. and China had agreed to a truce in their trade dispute, at least temporarily, in weekend meetings at the G20 summit in Argentina. But concerns rose on Tuesday after additional post-G20 details suggested that the United States and China had made no concrete progress on tariffs.
Meanwhile, the yield on three-year Treasury bonds rose higher than the yield on five-year Treasury bonds, a pattern known as “inversion” (normally, the yield curve slopes upward, as shorter-maturity fixed income securities typically offer lower yields than longer-term securities). While this segment of the yield curve is not one that investors tend to watch most closely, it was seen as a sign that a more significant yield curve inversion could be coming. An inverted yield curve is often seen as a recession indicator.
“This was an inversion in the ‘belly’ of the curve,” says Schwab Chief Investment Strategist Liz Ann Sonders. “Given that those inversions have always been followed by a subsequent inversion in the more commonly watched two-year/10-year and three-month/10-year Treasury curves, it rattled investors.”
Watching the yield curve
Although the key three-month/10-year Treasury yield hasn’t yet inverted, markets become concerned about curve inversion because it could signal a coming recession, according to Kathy Jones, Chief Fixed Income Strategist at the Schwab Center for Financial Research.
“Most recessions in modern history have been preceded by an inverted yield curve,” Kathy says. “However, there have been inversions that did not result in recession. Moreover the lag times between the inversion and a subsequent recession have been long and highly variable—anywhere from a few months to more than two years. It isn’t necessarily the best or most reliable timing indicator for a recession.”
The yield difference between 3-month T-bills and the 10-year Treasury bond was 57 basis points as of Tuesday’s close, which allows room for another rate hike or two by the Fed before an inversion, assuming longer-term yields remain steady, Kathy says.
While short-term interest rates are largely determined by Fed policy, long-term rates tend to reflect expectations for growth and inflation, Kathy says.
“Long-term rates are falling on signs that growth is slowing due to the lagged impact of Fed rate hikes to date on industries such as housing and autos, while trade conflicts are weighing on the prospects for global growth,” Kathy says.
International stocks may also face volatility
Although international stocks performed slightly better than U.S. stocks on Tuesday, “an inversion of the U.S. yield curve has historically signaled peaks for international stocks, as well,” says Chief Global Investment Strategist Jeffrey Kleintop.
International stock market investors also will be paying close attention to the Brexit debate in the UK parliament, as critics of a proposed deal for Britain’s exit from the European Union voice their challenges prior to a vote on Dec. 11.
“While there is a ‘no deal’ scenario with an abrupt and disorderly exit from the European Union, potentially leading to a recession in the UK, there are other ‘no deal’ options that could lead to a long transition period with a lesser impact,” Jeffrey says.
Nevertheless, international stock market volatility is likely to remain high, Jeffrey says. “Investors with longer time horizons are best served by staying diversified and making sure their portfolios are in line with their long-term asset allocation targets,” Jeffrey says. “Investors with shorter time horizons may want to consider underweighting emerging-market stocks, historically a highly volatile asset class.”
Considerations for long-term investors
It’s nearly impossible to time the market, and it’s generally healthier for your portfolio if you resist the urge to sell based solely on recent market movements. However, here are some things you might consider doing now:
- Revisit your plan and reacquaint yourself with your investment goals and objectives. If you’re not clear about your goals, this would be a good opportunity to craft a plan.
- Match your portfolio to the time frame of your goals. Make sure your portfolio is appropriate given your goals and objectives. Don’t focus only on investments designed to do well over the long-term if you have shorter-term needs.
- Revisit your risk tolerance. Volatility is often a wake-up call for investors who haven’t been engaged in their portfolios. If you’re not comfortable with your risk level, it may be prudent to dial back the overall risk in your portfolio, while taking into account both short- and long-term goals.
- Consider your investing life stage: If you’re near or already in retirement, you may want to review your portfolio and income requirements. If necessary, you may want to adjust your portfolio to help buffer the effects of a market downturn on a portfolio from which you’re taking withdrawals for income (or expect to start taking withdrawals soon).
What You Can Do Next
Learn more. Get additional guidance from Schwab’s experts on strategies for weathering market volatility.
Watch a short video. Kathy Jones explains the basics of the yield curve.