Markets plunged Friday when a closely watched economic measure warned that sluggish global growth could tip the United States toward recession.
All three major indexes saw a steep decline on worries that a recession may finally be on the horizon after a 10-year bull market and economic expansion.
The Dow Jones industrial average dropped 460 points, about 1.8 percent, when the 10-year Treasury yield fell below the 3-year yield. The so-called "inverted yield curve" is a historic precursor of a recession.
Stocks posted their worst day since Jan. 3.
"It is freaking the stock market because an inverted yield curve has a history of predicting recessions," said Ed Yardeni of Yardeni Research. "However, it is just one of the 10 components of the Index of Leading Economic Indicators, which remains on an uptrend."
The Standard & Poor's 500-stock index shed 1.9 percent. The Nasdaq composite fell 2.5 percent, its first drop in six sessions.
Dragging the Dow were Nike, DowDuPont and Caterpillar. Dow utilities showed strength as investors flocked to safety.
Financial services, energy and industrials were the hardest-hit sectors in the S&P 500.
The yield on the 10-year Treasury is closely watched in the financial world because many view it as a window on where the economy is headed: up, down or sideways. Yields work inversely to a bond's price.
When the 10-year yield is lower than the 3-year yield, it tends to signal that people are locking up money longer term because they fear a slowdown in business profits and its accompanying decline in stock prices.
But not all yield-curve inversions signal a recession is in the offing.
The Federal Reserve sensed a slowdown in the last few months, putting interest rates on hold until the U.S. economy adjusts to a more-rapidly decelerating global economy.
"The yield curve inversion, coming quickly after a dramatic 'about face' for the Fed, is undermining investor confidence," said Kristina Hooper, global strategist at Invesco. "At the end of the day, we have to remember that an inverted yield curve doesn't cause a recession, it's just a good indicator that one is coming. Investors should not be panicking."
The American economy is still remarkably healthy. U.S. stock indexes are near all-time highs, unemployment is near a record low, real wages are increasing, interest rates are fueling the economy with cheap money and oil is inexpensive.
But weak manufacturing data out of Germany on Friday showed a third consecutive month of dwindling activity, feeding into investor fears of a worldwide recession. Germany has been the eurozone's growth engine.
"This morning we got new statistics on a slowing economy, from both U.S. and German, adding to the market concern," said Howard Silverblatt of S&P Dow Jones indices.
The financial services sector was down 2.6 percent Friday - pulling it down 4.7 percent on the week - following dovish comments from Federal Reserve Chairman Jerome H. Powell on Wednesday.
"Banks have a harder time making money in a low-interest rate environment, so they are getting hit the worst," Silverblatt said. "They have fixed costs, and without higher interest rates, they have difficulty covering those costs."
This warning signal has a fairly accurate track record. A rule of thumb is that when the 10-month Treasury yield falls below the three-month yield, a recession may hit in about a year. Such an inversion has preceded each of the last seven recessions, according to the Federal Reserve Bank of Cleveland.
The last time a three-month Treasury yielded less than a 10-year Treasury was in late 2006 and early 2007, before the Great Recession made landfall in December 2007.
WHY DID THE YIELD CURVE INVERT?
Longer-term Treasury yields have been falling this year, in part on worries that economic growth is slowing around the world. When investors become nervous, they often abandon stocks and other risky assets and flock to Treasurys, which are among the world's safest investments. High demand for bonds will, in turn, send yields falling. Accordingly, the yield on the 10-year Treasury has sunk to 2.43 percent from more than 3.20 percent late last year.
Shorter-term rates, by contrast, are influenced less by investors and more by the Federal Reserve, which raised its benchmark short-term rate seven times over the past two years. Those rate hikes had been forcing up the three-month yield, to 2.45 percent from 1.71 percent a year ago. This momentum will likely slow now that the Fed foresees no rate hikes in 2019. But if longer-term Treasury yields continue to weaken, the curve could remain inverted.
IS IT A PERFECT PREDICTOR?
No, an inverted yield curve has sent false positives before. The yield curve inverted in late 1966, for example, and a recession didn't hit until the end of 1969.
HAVEN'T WE HEARD THIS BEFORE?
Other parts of the yield curve inverted late last year, as when the five-year Treasury's yield dropped below the three-year yield. Those parts of the yield curve, though, aren't as closely watched.
And not every part of the yield curve is inverted. Many traders on Wall Street also pay close attention to the difference between two-year and 10-year Treasurys. That part of the curve is still not inverted. The 10-year yield of 2.43 percent is still above the two-year yield of 2.32 percent.
SO IS A RECESSION COMING OR NOT?
It's too soon to say. Economic growth is slowing around the world, but the U.S. job market remains relatively strong.
"This is a signal that we should take seriously," said Frances Donald, head of macroeconomic strategy at Manulife Asset Management. "However, it's too early to tell whether this is indeed a harbinger of a recession or a blip. For me to feel confident to say this is a predictor of recession, I would need to see it persist for at least one to two months."
Potentially more concerning, Donald said, is how businesses and consumers react to the inverted yield curve. If they were to cut back on hiring or spending, that could trigger a self-fulfilling prophecy that leads to a recession.
"We're so accustomed to this telling us a recession is ahead that my concern is businesses and households get so scared they effectively create one," she said.
- Associated Press and Washington Post.