NEW YORK — Bonds sounded their loudest warning bell yet of recession on Wednesday, when the yield on the 10-year Treasury note briefly fell below the two-year yield.
When yields get “inverted,” market watchers say a recession may be a year or two away. When a short-term debt pays more than a long-term debt, it shows that investors are losing confidence in the economy’s prospects.
Investors responded by dumping stocks, more than erasing gains from a rally the day before. The Dow Jones industrial average dropped 800 points in afternoon trading. The S&P 500 index dropped nearly 3% as the market erased all of its gains from the day before. Tech stocks and banks led the broad sell-off.
The Nasdaq composite lost 242.42 points, or 3%, to 7,773.94. The Russell 2000 index of smaller company stocks slid 43.05 points, or 2.8%, to 1,467.52.
The losses come a day after stocks soared when President Donald Trump’s administration delayed tariffs on about $160 billion in Chinese goods that were set to take effect Sept. 1.
An inverted yield curve has historically been a reliable, though not perfect, predictor of recession. Each of the past five recessions was preceded by the two- and 10-year Treasury yields inverting, according to Raymond James, taking an average of about 22 months for recession to hit. The last inversion of this part of the yield curve began in December 2005, two years before the recession tore through the global economy.
Other parts of the curve have already inverted, beginning late last year. But each time, some market watchers cautioned not to make too much of it.
In December, for example, the yield on the five-year Treasury note dropped below the two- and three-year Treasury yields. It wasn’t a big deal at the time because academics and economists pay much more attention to the relationship between three-month yields and 10-year yields.
When the three-month yield rose above the 10-year yield earlier this year, it drew more attention. But traders said the inversion would need to last a while to confirm the warning signal, and they pointed out that the widely followed gap between the two-year yield and the 10-year yield was still positive.
Now, that tripwire has been crossed, too, and the three-month Treasury yield remains above the 10-year yield.
This latest inversion is the result of a steep slide in long-term yields as worries mount that Trump’s trade war may derail the economy.
Trump placed the blame for the “crazy inverted yield curve” squarely on the Federal Reserve, which he believes raised interest rates too quickly. The Fed’s reluctance to ease policy more aggressively is “holding us back,” he tweeted. He said Fed Chairman Jerome Powell is “clueless.”
Some market watchers say the yield curve may be less reliable an indicator this time because of technical factors that are distorting yields. Bonds in Europe and elsewhere have even lower yields than U.S. bonds and are negative in many cases. That’s sending buyers from abroad into the U.S. bond market, putting extra pressure downward on U.S. yields.
The Federal Reserve also is holding more than $2 trillion in Treasury securities, which it amassed to pull the economy out of the 2008 financial crisis and keep longer-term interest rates low.
Investors have been plowing money into the safety of U.S. government bonds for months as anxiety mounts that weakness in the global economy could sap growth in the U.S. Uncertainty about the outcome of the U.S. trade war with China has spurred a return of volatility to the stock market this month — the Dow has dropped more than 5% and the S&P 500 is down more than 4%.
Economic data from two of the world’s biggest economies added to investors’ fears Wednesday. European markets fell after Germany’s economy contracted 0.1% in the spring because of the global trade war and troubles in the auto industry. In China, the world’s second-largest economy, growth in factory output, retail spending and investment weakened in July.
“The bad news for global economies is stacking up much faster than most economists thought, so trying to keep up is exhausting,” Kevin Giddis, head of fixed income capital markets at Raymond James, wrote in a report.
One of the biggest concerns is that all the uncertainty around the U.S.-China trade war — where the world’s hopes of a resolution can rise and fall with a single tweet or statement — may cause businesses and shoppers to wait things out and rein in their spending. Such a pullback could hurt corporate profits and start a vicious cycle where companies cut back on hiring, leading to further cutbacks in spending and more damage for the economy.
Wednesday’s developments are the latest in a string of worrisome news about the U.S. economy. The government is expected to spend roughly $1 trillion more than it brings in through revenue this year, creating a ballooning deficit. Business investment has begun to contract — largely because of the uncertainty surrounding the trade war — and manufacturing jobs have begun to slide. The big hiring and investment announcements that piled up at the beginning of the Trump administration have ceased, as have the announcements of bonuses and pay increases that came after a tax-cut law was passed in 2017.
Several White House officials have become concerned that the economy is weakening faster than expected. The Treasury Department has had an exodus of senior advisers in recent months, and the White House just announced a replacement for the chairman of the Council of Economic Advisers.
Broader measures of the U.S. economy, meanwhile, are not pointing to an imminent downturn. The job market, consumer spending and consumer confidence all remain solid to strong.
“The only thing that’s flashing red or yellow right now is the yield curve,” said Jay Bryson, global economist at Wells Fargo.
Some investors believe an inverted yield curve is just a reflection of market worries that the economy is weakening and that the Federal Reserve needs to cut short-term interest rates. Others, though, say an inverted curve can help cause a recession itself by making lending less profitable for banks and cutting off growth opportunities for companies.
“For this reason, investors must not dismiss the current behavior in the fixed income market,” Natixis economist Joseph LaVorgna wrote in a research note.
Either way, some market watchers cautioned investors not to take the inversion as a panic signal and sell everything.
With bond yields falling, banks took heavy losses Wednesday. Lower bond yields are bad for banks because they force interest rates on mortgages and other loans lower, which results in lower profits for banks. Citigroup sank 5.3% and Bank of America gave up 4.7%.
Macy’s plunged 13.2%, the sharpest loss in the S&P 500, after it slashed its profit forecast for the year. The retailer’s profit for the latest quarter fell far short of analysts’ forecasts as it was forced to slash prices on unsold merchandise. The grim results from Macy’s sent other retailers sharply lower, too. Nordstrom sank 10.6% and Kohl’s dropped 11%.
Energy stocks also sank sharply, hurt by another drop in the price of crude oil on worries that a weakening global economy will drag down demand. National Oilwell Varco slumped 8% and Schlumberger skidded 6.6%.
The price of benchmark U.S. crude slid $1.87, or 3.3%, to settle at $55.23 per barrel. Brent crude, the international standard, dropped $1.82 to close at $59.48.
Wholesale gasoline fell 6 cents to $1.68 per gallon. Heating oil declined 4 cents to $1.84 per gallon. Natural gas fell 1 cent to $2.14 per 1,000 cubic feet.
Information for this article was contributed by Stan Choe, Alex Veiga, Bani Sapra and Christopher Rugaber of The Associated Press; by Katherine Greifeld and John Ainger of Bloomberg News; and by Damian Paletta, Thomas Heath and Taylor Telford of The Washington Post.