The Inverted Yield Curve – What Is It and Why Are Investors Interested?

Simply put, bond yield curves provide snapshots of interest rates (yields) of similar bonds, but at different maturities. For example, the interest rate on 2-year U.S. Treasurys recently was at 1.5% while 10-year U.S. Treasurys yielded 1.62%. If you graph the yields of similar types of bonds (e.g., Treasurys, corporates or municipal bonds) at maturities ranging from one month to 30 years, you get a picture of interest rates at a point in time. Investors pay attention to yield curves as changes in interest rates provide information about current financial markets.

Typically, long-term interest rates are higher than short-term interest rates (the yield curve is upward sloping). This makes sense to most people. Investors would expect to earn a higher interest rate on 5-year certificates of deposit (CDs) than on 90-day CDs.

Can Inverted Yield Curves Predict Future Stock Market Declines?

Recently, portions of the yield curve have inverted (short-term rates are higher than long-term rates.) Historically, there have also been several periods when the yield curve has been flat or inverted. One question often posed by investors is whether inverted yield curves predict a future stock market decline. While the handful of instances of curve inversions in the U.S. may concern investors, Dimensional Fund Advisors notes the small number of examples makes it difficult to determine a strong connection, and evidence from around the world suggests investors should not extrapolate from the U.S. experience.

The inversion prior to the 2008 financial crisis is interesting to review. The U.S. yield curve inverted in December 2005, after which the S&P 500 Index posted a positive 12-month return. The yield curve’s slope became positive again in June 2007, well prior to the market’s major downturn from October 2007 through February 2009. If an investor had interpreted the inversion as a sign of an imminent market decline, being out of stocks during the inverted period could have resulted in missing out on stock market gains. And if the same investor bought additional stock once the curve’s slope became positive, he would also have been exposed to the stock market weakness that followed.

International markets tell a similar story. In 10 out of 14 cases of inversion, local investors would have had positive returns investing in their home markets after 36 months. The results show that it’s difficult to predict the timing and direction of equity market moves following a yield curve inversion.

Can Inverted Yield Curves Predict Future Recessions?

Similar to the comments above, partial yield curve inversions in August amplified investors’ worries about an imminent U.S. recession. While stock market declines occur frequently outside of recessions, recessions often cause stock market slumps.

Ned Davis Research (NDR) studied historical 10-year to 2-year yield curve inversions. The results indicated that inversions are not a sufficient condition for recession. Recessions have not always followed inversions. When they have, however, the lead time to recession ranged from 10 to 22 months. NDR did note inversions have been followed by increased volatility in stock prices and slower economic growth over the next year. The firm also noted that recession risks rise more meaningfully if financial conditions tighten and/or when weakness in manufacturing sectors spreads to services sectors. Currently, with low unemployment, U.S. consumers are continuing to spend, and while manufacturing is slowing, service industries remain in expansion.

Interestingly, fears of recession appear to be affecting monetary policy by the Federal Reserve and fiscal (spending) policy of Congress and the Trump administration. Both monetary and fiscal policy levers are being pulled simultaneously, although perhaps not closely coordinated. The Federal Reserve cut short-term interest rates for a second time in September, loosening financial conditions. Fiscally, government spending remains out of control. In fiscal year 2019, the U.S. budget deficit is expected to run just short of $1 trillion. The Congressional Budget Office projects similar annual deficits for years to come. Given the choice of managing spending and cutting entitlement programs or spending on U.S. infrastructure projects, government policymakers are choosing to spend more to “help the U.S. economy.”

Summary

The yield curve is a tool used to understand the economy, but inversion should not be solely used to gauge investment decisions or enhance economic predictions. The inverted yield curve is providing evidence that the U.S. economy is in late-cycle expansion but not recession. It is indicating higher stock market volatility should be expected because the economy is late cycle.

Keeping in mind the value of the data provided by the yield curve, but recognizing its limitations, we think the best approach for investors is to develop and stick to long-term plans that are in line with their risk tolerance. Then, investors may be better able to look past short-term noise and focus on investing using a process that will help them meet long-term goals.