The U.S. Treasury 2-10 year yield spread is about to invert and that means stocks are on ‘borrowed time,’ says BAML

The spread between the U.S. 2-year Treasury note yieldTMUBMUSD02Y, +4.84%  and the 10-year note yieldTMUBMUSD10Y, +2.07%  is at its narrowest levels since 2007.

This flattening of the Treasury yield curve spells trouble for stock-market investors that are already on the back foot as geopolitical concerns and trade tensions undermine market confidence, analysts at Bank of America Merrill Lynch say.

With an inversion of the yield curve, or a negative spread between short-term and long-term yields, not far away, the bond-market recession indicator is on the precipice of flashing red.

“The equity market is on borrowed time after the yield curve inverts,” wrote BAML strategists in a Tuesday note.

A widely-watched gauge of the yield curve by market participants, the 2-year/10-year yield spread narrowed to 2 basis points on Tuesday, according to Tradeweb data.

An inverted yield curve often serves as a prelude to a recession because it indicates when monetary policy and financial conditions are too tight for the broader economy. A yield curve inversion along the 2-year/10-year spread has come before the last seven recessions.

Still, the widely varying lag times between an inversion and an economic downturn makes it difficult to say if an inverted curve points to an imminent economic growth slowdown.

Other yield curve measures have already inverted this year. Since May, the 3-month/10-year spread measure utilized by the New York Federal Reserve to analyze recession probabilities has been mostly stuck in negative territory.

But investors had previously pointed to the lack of an inversion on the 2-year/10-year spread as a sign that the bond-market was not pointing to a shuddering halt to economic growth. Rather, it suggested hopes that the Federal Reserve would secure a soft-landing for a U.S. economy through “insurance” interest rate cuts.

The renewed flattening of the curve could thus indicate that economic pessimism is gaining ground among bond traders, and that the Fed’s July rate cuts will prove the first of many as part of a full-blown monetary easing cycle.

Even if the 2-year/10-year spread inverts, equities do still have room to run higher — if only for a few months.

“After an initial post-inversion dip, the S&P 500 index can rally meaningfully prior to a bigger US recession related drawdown,” BAML strategists said.

When they crunched the numbers, they found that the S&P 500 tended to mount a last-gasp rally, peaking on average 7.3 months after an inversion along the 2-year/10-year spread.

On Monday, the S&P 500SPX, +1.64%  was off 4.7% from its record close established on July 26.

But when a recession did eventually hit, the S&P 500 on average lost around 32% of its value.

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