Yield Curve and Margin Debt Send Conflicting Signals

Major Moves

The U.S. Treasury yield curve has had an interesting month as it has slowly inverted from the belly of the curve outward toward the long end of the curve. The three-year Treasury yield – which is currently the lowest point on the yield curve – first inverted by dropping below the one-month Treasury yield on March 7.

The 10-year Treasury yield (TNX) took a few weeks longer but finally dropped below the one-month Treasury yield on Friday, March 22. Both the 20-year Treasury yield and the 30-year Treasury yield are still above the one-month Treasury yield, but at the rate we're going, we could see the entire long end of the yield curve inverted within the next month or two.

So why is an inverted yield curve important for the stock market? Why should stock traders care what bond traders are doing to the yield curve? In the past, inverted yield curves have been a forerunner for stock-market downturns. On average, it takes eight months for the stock market to peak and start moving lower once the Treasury yield curve inverts.

Of course, that is an average time frame, so a stock market downturn could come sooner or later than that. And just because something has happened over and over and over again in the past doesn't guarantee that it will happen again in the future, but this signal has a pretty good track record.

The reason that the inverted yield curve has such a good track record of foreshadowing market downturns stems from the fundamentals that drive a yield curve inversion. When investors are nervous about the economic outlook for the future, they tend to buy longer-term Treasuries to protect their capital. This increase in demand for Treasuries drives the price of Treasuries higher, which in turn drive the yield on Treasuries lower.

If investors are nervous enough, they will even buy longer-term Treasuries that have lower yields than shorter-term Treasuries just to lock in the yield for a longer period of time in the anticipation that the Federal Reserve will eventually be forced to start lowering short-term rates to combat an economic slowdown or recession.

S&P 500

The S&P 500 is doing a pretty good job ignoring the inverting Treasury yield curve for the moment. After slipping back below the key level of 2,816.94 last Friday, the S&P 500 managed to close above this level once again today – establishing a new higher low for the index in the process.

Like I said above, an inverted yield curve is a longer-term indicator that can take more than a year to play out, and right now, it looks like traders may want to take another swing at climbing back up toward the S&P 500's all-time high of 2,940.91.

Read more:

What Causes a Recession?

3 Ways to Take Advantage of a Recession

The Impact of an Inverted Yield Curve

Risk Indicators – Margin Debt

One of the driving forces that has lifted the U.S. stock market higher in 2019 has been the fact that buyers have been borrowing more money to invest. Buyers provide the demand in Wall Street's supply-and-demand equation, and sometimes buyers have so much demand that they choose to borrow money to buy stocks.

Traders can borrow up to 50% of the purchase price of a stock, according to Regulation T of the Federal Reserve Board. This means that, if a stock costs $100, you only need to put up $50 of your own money to purchase the stock. You can borrow the other $50. Borrowing money to buy stocks is referred to as buying on margin, and the amount of money you have borrowed to buy stock is called “margin debt.”

Tracking the total amount of margin debt being used to buy stocks in the market can give you a good sense not only of how much demand there is on Wall Street but also how confident traders are. Confident traders tend to borrow more because they believe that they are going to see a strong return on their investment. Nervous traders tend to borrow less because they are concerned that they could amplify their losses.

Margin debt reached an all-time high of $668,940,000,000 in May 2018 before it started to level off in mid-2018. By autumn 2018, margin debt had started to crater, dropping to $607,645,000,000 in October and then bottoming out at $554,285,000,000 in December. Not surprisingly, this drop in margin debt coincided with the bearish pullback in the S&P 500. When traders start selling positions to reduce their margin debt levels, the stock market doesn't have much of a choice but to move lower.

However, since December 2018, margin debt levels have begun to rebound. Margin debt climbed to $568,433,000,000 in January and – according to newly released data from FINRA – to $581,205,000,000 in February.

Unfortunately, FINRA releases its margin debt data a month behind. That's why we are just now seeing the data for February. We'll have to wait until the last week in April to see March's data.

Even so, the rebound in borrowing to buy stocks on Wall Street is an encouraging sign for the strength of the current uptrend. Plus, there is still plenty of borrowing that can be done before we reach the 2018 highs, which means there may be more upside for the S&P 500 so long as traders remain confident enough to borrow.

Read more:

FINRA: How It Protects Investors

Bull Market Gains Spur Rebound In Risky Margin Buying

How Much Can I Borrow With a Margin Account?

Bottom Line – Mixed Messages

It can be frustrating when the bond market is sending one message by creating an inverted Treasury yield curve while the stock market is sending the opposite message by breaking back above key resistance and by increasing its margin debt. Typically in these cases, I have found it useful to take note of the warnings from the bond market but to trade based on the stock market.

Traders on Wall Street have an amazing capacity to climb the wall of worry. Prepare, but don't panic.

Read more:

The New Apple Credit Card Is Built for Stickiness

The Average Retirement Savings by Age

Learn the Basics of Investing

Enjoy this article? Get more by signing up for the Chart Advisor newsletter.