By Noel Randewich and Saqib Iqbal Ahmed
SAN FRANCISCO/NEW YORK (Reuters) - A closely watched section of the U.S. yield curve inverted on Wednesday for the first time in over 12 years, rattling investors already worried that a U.S.-China trade war might trigger a global recession and kill off a decade-long bull market on Wall Street.
The yield on the U.S. 10-year Treasury (US10YT=RR) note tipped 1.4 basis points below 2-year Treasury yields (US2YT=RR), the first time this spread has been negative since 2007, which was the end of a trend of negative yield curves that started in 2005, according to Refinitiv data.
A yield curve typically has an upward slope -- when the yields are plotted on a graph -- because investors expect greater compensation for the risk of owning longer-maturity debt. An inversion, when shorter-dated yields are higher than longer-dated ones, is considered a warning of a looming recession.
(GRAPHIC - Yield curve inversions, recessions & U.S. stocks: https://tmsnrt.rs/2N3ciYM)
With inverted yield curves widely viewed on Wall Street as a major danger signal for the economy, Bank of America Merrill Lynch (NYSE:BAC) warned this week that Wall Street's decade-long rally is also under threat.
Inversions of the 2- and 10-year Treasury curve have preceded major sell-offs on Wall Street. With the S&P 500 (SPX) hitting record highs in July and up over 300% since the 2009 low following the financial crisis, the bull market's vulnerability is coming into sharp relief.
"The equity market is on borrowed time after the yield curve inverts. However, after an initial post-inversion dip, the S&P 500 can rally meaningfully prior to a bigger US recession related drawdown," Bank of America Merrill Lynch analysts wrote in a report on Monday.
After previous inversions since the 1950s, the S&P 500 has typically fallen about 5% over one or two months, followed by a "last gasp" rally of an average of 17% and lasting about seven months, according to Bank of America.
The chart below shows that stocks in some cases continued to grind higher for many months after the yield curve inverted. Since 1980, stocks delivered positive one-year returns following yield curve inversions. It is only three years out from the inversion that stocks have registered significant losses.
(GRAPHIC - Yield curve inversions, recessions & U.S. stocks: https://tmsnrt.rs/2N3RmRs)
S&P 500 corrections related to recessions average 32% and tend to last just over a year, according to Bank of America Merrill Lynch.
The graphic below shows that the S&P 500 had a negative three-year performance following yield curve inversions in 2000 and 2006, but not in the 1980s.
(GRAPHIC - Yield curve inversions, recessions & U.S. stocks: https://tmsnrt.rs/2YOtvft)
The spread between U.S. 2-year and 10-year note yields has slipped below zero before each of the last five U.S. recessions, although it has taken anywhere from 12 to 24 months for the recession to occur. The curve's inversion often ended before a recession began, and the inversions did not predict the length or severity of an economic downturn.
U.S. central bankers and many other economists and investors have said that an inverted yield curve would be most concerning if it lasts for a prolonged period.
"It needs to stay there for a while, typically a quarter or two, for it to have predictive value," said Hank Smith, co-chief investment officer at Haverford Trust in Philadelphia.
After the curve last inverted in December 2005, the S&P 500 kept rising through the next year before tumbling by 2009 to around 35% below its levels prior to the yield curve inversion. By 2010 the S&P 500 had recovered, although financials remained down over 40%.
(GRAPHIC - 2005 yield curve inversion: https://tmsnrt.rs/2YP8IZl)
Prior to that, the yield curve inverted in 2000 during the dot-com bubble. By early 2003, the S&P 500 had fallen about 40%, and it was still down almost 20% five years later. By 2005, technology stocks were still down close to 80%.
(GRAPHIC - 2000 yield curve inversion: https://tmsnrt.rs/2YJW1yR)
In March, the gap between 3-month T-bills and 10-year notes inverted for the first time in about 12 years. That metric, which some economists focus more on than on the 2-year and 10-year spread, reverted back and then inverted again in May. It is now trading at negative 37 basis points.