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The Yield Curve Inverted - Is a Recession on the Horizon?

If you're paying attention to the talking heads, you have probably heard that the yield curve recently inverted.  The yield curve is the “connect-the-dot” line that follows the yield of treasury bonds with maturities from 1 month to 30 years.  Typically, this curve is sloped upward, as longer-term bonds demand a higher yield.  In a healthy economy, when long-term growth is expected, higher long-term yields are indicative that investors have positive feelings about growth in the economy.  Here’s what you need to know!

What is a yield curve inversion?

The yield curve is “inverted” when shorter-term maturity bonds are yielding more than longer-term maturity bonds.  The yield curve has been inverted or close to it at different points for a little while now, but the relevant inversion that could indicate a recession is the 3-month vs the 10-year treasuries.  This happened on 3/25/19, when the 3-month yield was 2.46% vs the vs. the 10-year yield of 2.43%.1 

Why is this bad news?

Historically, a yield curve inversion between the 3-month and 10-year treasuries has been a fairly reliable indication that the economy is headed for a recession.  If lenders are willing to accept less interest on money they commit for a longer time period, it is an indication that they believe yields of shorter-term maturities are about to fall.  This typically happens due to the Fed cutting rates, which they typically do to provide support to a struggling economy.

How reliable of an indicator is it?  What should we expect from here?

It has predicted 6 of the last 8 recessions.2  So it is batting .750 which is fairly solid, even considering the  small sample size.  Going back to the 1970s, it has taken an average of 350 days for the market to peak following the yield curve inversion, and the market has earned an average of 22% in those time periods.3  So it could be 6 months.  It could be 2 years.

What about this time?

It is important to understand a few things.  First off, the yield curve inversion is a symptom of a recession, not a catalyst.  The only way a yield curve inversion can really cause a recession is if the groupthink of irrational investors compounds into a level of fear that leads to a selloff.  This is unlikely, but possible.

Secondly, the term “recession” refers to the economy – not necessarily the stock market.  Stocks do not move in lockstep with the economy, though they are closely related.  The last recession, the one everyone remembers, included a peak-to-trough drop of 51% in the S&P 500.  This was an outlier, not the norm.  A recession could mean a drop of 20 – 25%.  If you missed it, the S&P 500 actually experienced an intra-day peak-to-trough drop of 20% in the 4th quarter and has almost completely recovered already.

When analyzing a yield curve inversion, it is important to keep perspective.  Is this a long-term factor or a flash in the pan?  As of the time this was written, the inversion is a very small spread and it has only lasted a few days.  When it is inverted by .15-.3% for 3 months or longer it should be taken more seriously.

It is also important to understand why the yield curve inverted this time.  Looking back at the last 8 inversions referenced above, typically when a recession has followed, the inversion was mostly due to the shorter-term rate rising than the 10-year dropping.  In other words, the Fed raising rates too aggressively was a major contributor to most of those yield curve inversions and the following recessions.

The good news about today’s inversion is that it has been more about the 10-year dropping than the expectation of an aggressive Fed.  In fact, the Fed has expressed a very cautious tone, which makes us a little more comfortable.

The economic conditions surrounding the inversion are obviously important considerations as well.  In our case today, the labor market is strong.  Expectations of inflation are very mild.  As stated previously, the Fed has expressed a willingness to be patient.  Equity valuations are nowhere near bubble territory.  In fact, they are fairly reasonable as earnings continue to climb.  All of these factors point to the cycle extending.

Make no mistake, we do believe the rate of growth is slowing down and we are likely in the late growth stage of the business cycle.  Realistically, it almost has to slow down after a year like 2018.  But the market has an excellent chance of gains amidst slowing growth, in our opinion.  A recession, by definition, is when we see negative growth, not slowing growth.

Our advice, as always, is to have a plan and stick to it.  Bear markets are both unpredictable and inevitable.  It is far wiser to adjust to their existence than try to predict them.  While you will never see us overreact to the headline of the day, it is something that will factor into our investment strategy moving forward.  When recessionary signals like this arise, it is wise to proceed with caution. 

 

Registered associates of Bluestone Wealth Partners are registered representatives of Lincoln Financial Advisors Corp. Securities and investment advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. Bluestone Wealth Partners is not an affiliate of Lincoln Financial Advisors Corp.  CRN-2481741-032919

1Source:  U.S. Department of the Treasury, https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield

2Source:  Oppenheimer, https://www.oppenheimerfunds.com/advisors/article/the-curve-inverted-dont-worry?CMPID=EAMZZ1510000494AN&SID=217&AN=OFIBLG_201611&om_rid=AAAAAA&om_mid=2267273&BID=&CID=&OPT1=&OPT2=&OPT3=

3Source:  JP Morgan, https://am.jpmorgan.com/us/en/asset-management/gim/adv/insights/3-things-to-know-about-the-inverted-yield-curve