The Implications of an Inverted Yield Curve

Jennifer Hutchins, CFA, Portfolio Manager
January 8, 2019

An inversion of the U.S. Treasury yield curve has historically been viewed as a sign of an approaching recession, but before fleeing the market, one should consider an inversion within the context of the current market environment.

First we must define what is meant by “inversion.” A typical U.S. Treasury yield curve is upward sloping, with longer-term bonds yielding more than shorter-term bonds due to a perceived term premia built into longer maturity bonds. Premia is the additional yield added to the “neutral rate” that a bond holder should receive to be compensated for taking longer term risk. The “neutral rate” is a perceived rate which is considered neither accommodative nor restrictive for the current economic environment. There are several ways in which one may attempt to calculate the neutral rate but a “true” neutral rate is unobservable.   This additional risk premium includes anticipated economic growth, the potential future inflation and future supply and demand for government bonds.

The 10-year US Treasury note is a typical reference point that many people use to gauge economic sentiment about the future. The short-term gauge is typically the 2-year US Treasury note, which has some term premia but is mostly driven by the neutral rate and Federal Reserve (Fed) monetary policies. The yield curve is said to be “inverted” when shorter-term Treasury securities are yielding more than longer-term Treasuries. The standard practice is to view the spread between the 2-year and the 10-year US Treasury note as the main indicator of an inverted yield curve. This is called the “term spread.”

Recently, we have seen parts of the Treasury slope invert, with 2-year U.S. Treasury yielding more than the 5-year. However, as of Dec. 12, 2018, both the 7-year and the 10-year U.S. Treasury are yielding more than the 2-year note. Does this mean that a recession is looming on the horizon? What does this inverted yield curve signal? Let’s parse this event further.

This current inversion signals that monetary policy is anticipated to be more restrictive. This is not surprising considering we have had near-zero Federal Funds interest rates since 2008. In the US, there appears to be a link between the inversion of the term spread and a recession albeit with only a few data points to include in this observation.

However, we are in a different market environment than is typically seen at the end of an expansionary period. Normally, a recession is driven by an over-heating market with rising inflation that the Federal Reserve tries to repress by raising interest rates. Today’s economic environment, however, is characterized with muted inflation and rates below the perceived neutral rate. Moreover, quantitative easing, an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply, has kept rates unnaturally low, placing pressure on term premiums as well. Today’s inflation risk seems less obvious than historically seen at the end of an expansionary phase.

While the inversion of the U.S. Treasury yield curve has been a predecessor to several recessions since 1970, the sample size was small, with approximately seven recessions since 1970. By increasing the sample size to five of the largest developed countries (Australia, Germany, Japan, the U.K., and the U.S.), one can get a better perspective of the inverted yield curve indicator. Collectively, the returns of the MSCI local currency indices increased 86 percent of the time during a 12-month period after an inversion and 71 percent 36 months after an inversion. Thus, a yield curve inversion does not always mean a recession may be imminent.

Lastly, the amount of time before a bear market strikes can vary, and investors can potentially miss out on significant gains if they pull out of the market too early. The yield curve inverted in February 2006, well before the down market swing in October 2007 preceding the 2008 financial crisis. Yet if one had pulled out of the market in February 2006, one would have missed out on a 12-percent gain posted by the S&P 500 over the next 12 months. In fact, if one pulled out prior to Oct. 14, 2007, one would have missed out on a cumulative 25 percent gain in the S&P from March 1, 2006 through Oct. 14, 2007. Also, in 1998 the yield curved inverted briefly and a recession did not follow.

While no one knows whether a recession will follow the recent curve inversion, this is certain: markets go up and down, and trying to time the market perfectly is nearly impossible. By working together, investors and their trusted financial advisors can build long-term plans to withstand inversions, volatility and anything else that threatens the achievement of one’s financial goals.

 

 

 

 

Securities offered through 1st Global Capital Corp. Member FINRA, SIPC. Investment advisory services offered through 1st Global Advisors, Inc.

Past performance is not a guarantee of future results.  The views and opinions expressed herein are for informational purposes only and should not be construed as investment advice.

Data Sources: Morningstar Direct and Bloomberg

Other Sources:

Levitt, Brian. “Shape of the Yield Curve May Be Best Economic Indicator.” Oppenheimer Funds. Markets &Economy, March 21, 2018.

Rosenberg, Jeffrey. “What 1969 can teach us about today’s flat yield curve.” BlackRock Investment Institute, June 4, 2018. https://www.blackrockblog.com/2018/06/04/flat-yield-curve. Accessed Dec. 7, 2018.

Hooper, Kristina. “Stock losses snowball across the globe in a December sell-off.” Invesco US Blog. Expert Investment Views, Dec. 6, 2018. https://www.blog.invesco.us.com/stock-losses-snowball-across-the-globe-in-a-december-sell-off. Accessed Dec. 7, 2018.

Hooper, Kristina. “Yield signs: Deconstructing a key market indicator.” Invesco US Blog. Expert Investment Views, April 23, 2018. https://www.blog.invesco.us.com/US-treasury-yield-key-market-indicator. Accessed Dec. 7, 2018.

Cox, Jeff. “Yellen indicates that Fed may not need to hike rates much more.” CNBC. The Fed, July 12, 2018. https://www.cnbc.com/2017/07/12/dovish-yellen-indicates-that-fed-may-not-need-to-hike-rates-much-more.html. Accessed Dec. 12, 2018.

 

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