In the fourth quarter of 2018, the market fell into a downtrend primarily because investors thought the Fed was too hawkish as the economy weakened. Jerome Powell reversed his view and embraced a much more-dovish tone, which produced a furious rally for the last two and a half months.
Last week, the Fed sounded even more dovish than previously, but that started to stir up concerns that, perhaps, there was real danger that a recession was lurking. This worry was solidified when the yield on the 10-year Treasury note fell to 2.439%, which is roughly 3 basis points lower than the 3-month Treasury bill. This is an inverted yield curve -- and the conventional wisdom is that it is a signal that a recession is brewing. The thinking is that when longer-term rates are lower than short-term rates, then there is expectation that the economy is going to weaken in the future and it is better to borrow short term.
On Friday, this made for a very convenient reason to take some profits after the big run from the December lows. The indices have been extended and in need of some consolidation, and it was ready to embrace this negative narrative.
Whether this issue gains further traction remains to be seen. Some pundits say that the yield curve has been quite flat for a long time, so it really is not a big shift. Former Fed Chair, Janet Yellen, said that the inverted yield curve may indicate a need to cut interest rates, rather than a recession.
In addition to the yield curve issue, the market has two other issues that will affect the action this week. The first is the Mueller Report, which concluded that there is no Russian collusion. This removes a great amount of the uncertainty that has hung over President Trump for the last two years. But the focus now is shifting to a battle over obstruction of justice. The Democrats are going to pursue this issue aggressively, but they have been badly weakened in their effort. They may cause the hostility to expand even more, but the chances of impeachment and other political drama has declined -- and that is a market positive.
The second issue that we will hear about this week is China trade negotiations. U.S. negotiators, headed by Treasury Secretary Mnuchin, are headed to China this week and we will likely see some headlines about progress. The market has become increasingly skeptical about a deal recently, so there is a good chance of a strong positive reaction on an indication of progress, but these are tough negotiations and progress may be very slow, which will worry the market.
We have a slightly positive open developing, but market players are nervous about the potential for the inverted yield curve to be a continued problem. This issue has weighed on the market a few times in recent years -- and was overcome fairly quickly, but it is potent ammunition for the bears that have to fight an uber-dovish Fed.
My game plan here is a more-defensive posture and tighter stops. The risk of further downside is high and I will be focused on protecting capital to a greater degree.