It is often said that an inverted yield curve has a perfect track record of predicting recessions. While this isn’t entirely true, its track record does suggest investors should take notice. Especially now as a couple measures of the yield curve are now inverted.
The yield curve is the difference between short-term and long-term interest rates. Under normal economic conditions, the yield curve is positive. Meaning that long-term interest rates are higher than short-term rates. However, as the Federal Reserve raises interest rates, eventually, the difference between short-term and long-term rates narrows.
Yield Curve and Economic Cycles
Looking back over multiple economic cycles, the yield curve falls below zero prior to recessions. When this occurs, it suggests that the Fed has raised rates too far and their policies are slowing the economy. Investors buy long-term bonds in an effort to profit from the Fed lowering interest rates. Remember, bond prices move in the opposite direction of interest rates. This means that when the Fed lowers interest rates, the market value of bonds rises.
An inverted yield curve is the bond market signaling that the Fed needs to cut rates. The market is usually right, eventually. The chart below is one we shared last week and shows the forward return for the stock market alongside the yield curve. Notice that shortly after the yield curve inverted in 2000 and 2006, the future return of the stock market declined significantly. The chart below uses the 10-year minus the 1-year treasury.
The problem today is that some yield curves are inverted while others are not. There are numerous curves created by comparing any two bond maturities. For example, many economists use the 10-year minus the 3-month treasury yields, while some academics use the 5-year minus the 3-month. Coincidentally, those two measures of the curve have inverted. A sign that a recession may be looming in the not too distant future.
On the other hand, there are a variety of other measures of the curve that are not inverted. The chart below shows nine different yield curves. The two mentioned above have inverted, while the other seven are still positive. During previous business cycles, more yield curves were inverted than just two.
A period in history that bares some similarity to today is the mid-1990’s. In both 1995 and 1998, many yield curves were flat or inverted, but not all of them. The late 90’s produces phenomenal returns for equity investors, averaging more than 20% per year. It wasn’t until the year 2000, when the bull market ended with the bursting of the Dotcom Bubble. Note that in 2000, nearly every measure of the yield curve had inverted.
Should Investors Respond?
One shouldn’t make a wholesale change to their investments just because one indicator suggests tough times are ahead. Instead the yield curve should be one piece of a comprehensive assessment of the future. Our Business Cycle Indicator uses the yield curve in conjunction with other financial and economic data to measure the direction of the US economy. It has a solid track record of anticipating recessions over the last 50 years.
The inversion of portions of the yield curve should serve as a warning sign that this economic cycle may be getting close to an end. When this cycle ends, the investments that have rewarded investors over the last ten years will likely become a source of loses (i.e. – stocks). This does not suggest that it is the time to panic; not at all. However, this is a good time to address how one’s investments are positioned and how they might fare during an economic downturn. Having an action plan for how to respond during the next recession will be a huge factor in determining an investor’s results over the next 3-5 years.