The spread between 5-year US treasury yields and 2-year/3-year yields went below zero this week (on December 4th), generating much commentary about what this means for the economy and markets. With good reason. The yield curve inverted prior to each of the last nine recessions. There was only one false positive, in the mid-1960s, which was followed by an economic slowdown.
We have written about inverted yield and recessions in the past (including a paper in 2015) and a flattening yield curve has been on our watchlist for more than a year now. A couple of months ago we asked the question whether hawkish Federal Reserve policy will invert the yield curve by the end of the year, even as we highlighted a brief inversion in the real yield curve. Of course, a flattening curve is not indicative of a recession – only an inverted one is – but flattening obviously precedes inversion. Which is what we got this week.
The following chart shows the nominal and real US treasury yield curve as of December 4th, compared to the end of last year. The tonal shift from policymakers this year has led nominal and real yields higher across the yield curve. Yet yields on the shorter end have gone up more, leading to a flatter curve and now partly inverted curve. The bond market is clearly less optimistic about future growth prospects than the Fed.
Focusing on the nominal curve, inversion has so far occurred only in the so-called belly of the curve (a partial inversion). We are more or less talking about medium-term rates, whereas yield curve inversion typically refers to the case when long-term rates are below yields at the short end of the curve. For example, the spread between 10-year yields and 3-month/1-year/2-year yields – let’s call these a full inversion.
Looking back in history we do see that a partial inversion is typically followed by a full inversion, and shortly thereafter by a recession. As we mentioned above, the mid-1960s was the only exception. The table below shows ten instances since the mid-1950s when the 5-year minus 3-year spread went negative. Also shown are lead times to an inversion in the 10-year minus 1-year spread, and recessions.
The average lead time to a full inversion is 4 months, though this is skewed by the large 21 month lead time we saw in the late 1990s. More often than not, a full inversion occurs within a month or two of partial inversion.
What is important is that a full inversion is not immediately followed by a recession. The lead time here is about 14 months on average, and ranges between 7 and 24 months.
What about equity markets?
We also looked at how the equity market performed in the wake of a full inversion (reversal in 10-year minus 1-year spread). The next chart shows equity market performance in those nine instances when the yield curve correctly predicted a recession. Each panel illustrates cumulative gains for the S&P 500 price index between the end of the month in which full inversion occurred through to the end of the recession. We use the highest values attained by the index in each month following inversion.
The idea is not to illustrate a trading strategy, but to show how high the index ran up after full inversion, if at all. The gray shaded area in each panel highlights the recession period and we should point out that the start and end points for recessions are typically announced well after it has passed.
In seven out of the nine cases, the S&P 500 gained 5% or more in the months between inversion and the start of the recession. The exceptions are 1973 and 2000.
In 2006 and 2007, the price index gained more than 23% in the months following full inversion (which occurred in January 2006). It ended up losing all those gains and fell by another -35% amid the financial crisis.
Interestingly, in four out of nine cases (1960, 1980, 1981 and 1990), the S&P 500 price index gained across the entire period between full inversion and the end of the recession.
So there is no cut and dry case for exiting all equity positions immediately after a yield curve inversion. As with any economic indicator, including one with a track record as the yield curve, it is best to probably combine it with other indicators.
Not to mention keeping an eye of how the Federal Reserve moves from here. This past summer we wrote about how the mechanism that links yield curve inversions to recessions is not clear. So there is always a question of whether “this time is different” – including by Fed Chair Ben Bernanke after the yield curve inverted in 2006. In this cycle, a lot of focus has fallen on the fact that global bond markets have been warped by unconventional monetary policy over the past several years. Bernanke, once again, suggested that the yield curve’s power to signal a recession may have diminished because normal market signals have been distorted by regulatory changes and quantitative easing in other jurisdictions.
In our piece, we discussed how monetary policy largely works through housing. Past expansions saw residential investment as a share of GDP shrink over the course of the tightening cycle and into the recession. However, residential investment is only 3.9 percent of GDP currently, which is significantly lower than where it was at the beginning of prior tightening cycles. This raises the question as to whether tighter monetary policy will (negatively) impact the economy in the same way it has in previous cycles. Or in other words, if monetary policy largely works through housing, and if housing is a much smaller part of the economy now than in the past, perhaps monetary policy will have less of an impact.
We also explored the role of tight fiscal policy in a follow up piece. Previous yield curve inversions, and subsequent recessions, have coincided with tight fiscal spending, or government austerity. That is not the case today. For the first time in recent history, the federal government is pushing its deficit even higher this far into an expansion, which is already slated to become the longest expansion on record. Could this time be different thanks to unorthodox fiscal policy that may have pushed a potential recession even further into the future?
On the other hand, as Minneapolis Fed President Neel Kashkari points out, “this time is different” may be the four most dangerous words in economics.
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