This Market Indicator That Frequently Signals a Recession Just Flashed Red

Going out of business sign

World stocks tumbled to one-week lows on Wednesday, as declines by long-dated US bond yields and a renewal of trade concerns stoked fears of a downturn in the world's biggest economy, the United States.

Adding to worries over the outlook for the global economy, the yield curve between US three-year and five-year notes, and between two-year and five-year paper inverted on Monday - the first parts of the Treasury yield curve to invert since the financial crisis, excluding very short-dated debt.

The Treasury "yield curve" can be seen as a proxy for investor sentiment on the direction of the economy. If the trend in the graph below continues, there could be a two-year/10-year yield curve inversion by the end of 2018.

The inverted yield curve persists for a second day.

Failure would raise the spectre of fresh USA tariff action and potential Chinese retaliation as early as March.

While the more closely watched part of the Treasury yield curve - the gap between two-year and 10-year yields - remains upwardly sloped, it flattened to just 15 basis points Monday. The 10-year Treasury note yield fell about 6 basis points to 2.498% Tuesday, its lowest since September 13, while the spread between 2-and 10-year notes dropped to 0.14%, the flattest level since June 2007, setting the tone for a possible inversion of spreads in the future. Shanghai markets (.SSEC) fell 0.6 percent, their losses limited by Chinese officials expressing confidence that a trade deal would be clinched on time.

"This solidifies not only my flattening bias but I think it will lead many players in the market who [expected the yield curve to steepen] to capitulate on that", Ian Lyngen, head of united rates strategy at BMO Capital Markets, told CNBC.

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Defensive Utilities .SPLRCU eked out a 0.2 percent gain, the only one of the 11 major S&P 500 sectors in positive territory. The yield on the 10-year Treasury note fell to 2.91 per cent from 2.99 per cent late Monday, a large move.

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However, investors are increasingly concerned by a flattening of the spread between 2-and 10-year Treasuries, a more fundamental benchmark of market health.

The bad news for investors is that inverted yield curves have preceded each of the past nine USA recessions. It was still positive on December 4 at 0.12 percentage points. Of course, that's still "pretty doggone tight", said Randy Frederick, vice president of trading and derivatives at Charles Schwab.

United States three- and five-year Treasury yields have inverted, while the two-year and 10-year benchmark is flattening.

"Inversion of that curve is the real recession red flag", said Neil Wilson, the chief market analyst at Markets.com.

"The market decline in the USA overnight and the flattening of the yield curve reflect that economic growth momentum is taking over as the primary concern for investors", Tai Hui, a strategist at J.P. Morgan Asset Management told clients.

The yield curve inversion and comments from Fed speakers are causing investors to rethink the potential of a recession or if rate hikes are nearing the top, said Minh Trang, senior FX trader at Silicon Valley Bank in Santa Clara, California. On Tuesday, the Dow Jones Industrial Average fell almost 800 points, or 3.1%, largely in response to recession fears stoked by recent changes in the yield curve.

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