The market's favorite recession indicator just flashed the strongest warning since 2007

  trader financial crisis AP / Richard Drew

  • The spread between 3-month and 10-year government yields – a ratio known as the yield curve – returned to its widest level since 2007 on Monday.
  • Investments in the yield curve have long been considered for indications of an imminent recession, and this is the latest signal that an economic downturn is coming.
  • This particular rate of return has turned before every recession for the past 50 years. [1[ads1]9659004] The latest strengthening of the curve was driven by escalated trade war tensions between the United States and China.
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The spread between 3-month and 10-year government bonds – a ratio known as the yield curve – turned to the widest level since 2007 on Monday.

At the widest point, the spread reached minus-32 basis points. This is a worrying sign for both economists and traders, considering such an inversion has preceded every US recession over the past 50 years.

And while the relationship has been in negative territory for months now, it is the severity of today's shifts – and the causes of it – that have traders on duty.

This latest escalation was spurred by the Chinese central bank's decision to allow the yuan to slide below a key dollar-to-dollar limit. China also said that will stop importing US agricultural products .

Together with President Donald Trump's announcement that he would extend the tariffs to virtually all imports from China from September, it marked the perfect blend of bearish headwinds. Shares responded in form, sold heavily and posted their worst day in 2019.

As for the curve itself, the extended spread was driven more by a 10-year decline than an uptick in its 3-month counterpart. The 10-year interest rate is at its lowest level since October 2016, and has been pushed lower as risk-averse investors have purchased Treasurys. The Federal Reserve's continued monetary relief has also played a role.

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In new research published Monday, Morgan Stanley agreed with the idea that increased tensions in the trade wars could accelerate a recession. Chetan Ahya, the company's chief economist, said a global recession could be on the horizon in nine months.

Meanwhile, investors are wondering what the latest trade escalation – and the deepening of the inversion in the yield curve – will mean for the Fed's future interest rate decisions.

UBS economist Seth Carpenter said Monday that more tariffs will slow the economy and make cuts easier to justify. According to his estimate, tariffs will take about 25 basis points from the U.S. gross domestic product from the fourth quarter of this year through 2020.

"Powell has argued for a cut based on the risk associated with tariffs; now that escalation is real, his case will be easier to do for skeptics at FOMC, "Carpenter wrote.

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