U.S. stocks finished slightly mixed last Friday, with the S&P 500 and Dow Industrials posting their first weekly losses in more than two months and the NASDAQ Composite ended a run of six straight weekly gains. Investors turned skittish after Republicans made little progress towards passing tax cuts with the Senate version differing from the House version, especially regarding the timing for corporate tax cuts. This, in turn, triggered weakness in small cap stocks, which would benefit the most from a corporate rate cut. Most losses occurred on Thursday and Friday, after all three major U.S. equity indices closed at new record highs on Wednesday. Trading volume was relatively slow, as many banks were closed for Veterans Day.
For the week, the S&P 500 declined by -0.14%, the Dow Industrials lost -0.50% and the MSCI EAFE (developed international) fell -0.40%.
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The chart illustrates the difference (spread) between the yields of the 10-Year and 2-Year Treasury notes, which is often referred to as the “10-Year/2-Year spread.” The metric is usually an early and reliable predictor of an upcoming recession.
Under normal conditions, the 10-Year/2-Year spread is positive, as investors demand a higher risk-premium for longer-term bonds. Yield spreads are usually wider early in an economic recovery, and narrow as growth sets in. As the onset for a recession becomes more likely, spreads tend to move toward zero or turn negative. This occurs because in periods when economic growth slows, inflation decreases and demand for credit declines, pushing long-term rates lower.
Over the last 40 years, the average 10-Year/2-Year spread has stood at 0.97%, and for the last 20 years the historical average is 1.30%. The last month-end reading of 0.81% is below average - the spread has only been this low 31% of the time over the last 20 years. This is consistent with the current stage of the economy, which may be characterized as continuing a late-cycle expansion when spreads typically are lower. We believe the recent spread levels indicate continued growth.