What could a yield curve inversion mean for stocks?
Key takeaways
The yield curve has flattened
What does inversion indicate?
It’s not time to panic
Among the most meaningful tips I received in my young career is that of all the indicators that signal what the economy may do next, the bond market gets it right most often. Thus, when the US Treasury yield curve meaningfully flattens, I pay attention. Every recession over the past 60 years has been preceded by an inversion of the yield curve.1
What’s the yield curve telling us now?
As I write this, the spread between the 10-year US Treasury rate and the 2-year US Treasury rate is only 22 basis points, and the forward curve suggests that the 2s/10s spread may be inverted within a matter of weeks.2 Is it time to call the imminent end to the current business cycle and to meaningfully reduce our equity exposure?
Not so fast. An inversion of the yield curve is a warning signal of future economic woes. Over the past six decades, the median amount of time between the initial inversion of the yield curve and the onset of a recession is 18 months.3 While a good indicator of future economic woes, an inverted yield curve has not been a very good timing tool for equity investors. For example, investors who sold when the yield curve first inverted on Dec. 14, 1988, missed a subsequent 34% gain in the S&P 500 Index.4 Those who sold when it happened again on May 26, 1998, missed out on 39% additional upside to the market.5 In fact, the median return of the S&P 500 Index from the date in each cycle when the yield curve inverts to the market peak is 19%.6
Historically, stocks have continued to rise even after the yield curve inverts
Inversion Date |
S&P 500 Index Peak Date |
S&P 500 Index % Change |
# of Months from Inversion to S&P 500 Index Peak |
Recession Start Date |
# of Months from Inversion to Recession |
|---|---|---|---|---|---|
Dec. 17, 1965 |
Nov. 29, 1968 |
17.69% |
35 |
December 1969 |
48 |
March 30, 1973 |
Jan. 11, 1973 |
NA |
-2 |
November 1973 |
8 |
Aug. 17, 1978 |
Jan. 30, 1980 |
9.63% |
17 |
January 1980 |
17 |
Sept. 11, 1980 |
Nov. 11, 1980 |
11.83% |
2 |
July 1981 |
10 |
Dec. 14, 1988 |
July 16, 1990 |
34.02% |
19 |
July 1990 |
19 |
May 26, 1998 |
March 24, 2000 |
39.62% |
22 |
March 2001 |
34 |
Dec. 27, 2005 |
Oct. 9, 2007 |
24.56% |
22 |
December 2007 |
24 |
Aug. 26, 2019 |
Feb. 19, 2020 |
19.13% |
6 |
March 2020 |
7 |
|
Median |
19.13% |
18 |
|
18 |
Sources: National Bureau of Economic Research, Bloomberg, L.P. The S&P 500 Index is a market-capitalisation-weighted index of the 500 largest domestic US stocks. Indices cannot be purchased directly by investors. Past performance does not guarantee future results.
Where do we go from here?
The current shape of the yield curve is a signal of what we already believe — inflation is too hot, and growth is going to moderate, albeit from a very robust pace. In my view, recession talk is premature, with household net worth up 17% over the past year,7 retail sales up 18%,8 and industrial production up 8%.9 Nonetheless, we recognise that the cycle is unlikely to last for as long as once hoped. Other great advice received in my youth is to not fight the Fed. Inflation hastens monetary policy tightening which hastens the end of cycles, plain and simple. That said, the Fed is behind the curve and will likely not drive the federal funds rate above long rates until the beginning of 2023 at the earliest.
So, there’s likely time, although the risks are rising. Equity investors should be mindful to not overreact when the yield curve first inverts. It’s a red flag, but not a great near-term timing tool. As someone once advised me, it’s not the first rate hike of the cycle that typically matters for equities, it’s usually the last one.
