The Economic History And Predictive Potential Of Inverted Yield Curves

The media has recently been buzzed with speculation about a potential looming economic slowdown triggered by trade tensions and signaled by what’s called an “inverted yield curve.” Let me suggest that we consider all the data before drawing any conclusions about the economy’s future prospects.

“But Wes,” my clients have asked, “Aren’t we close to this scary inversion, and doesn’t that mean we’re headed towards a recession?” Let’s talk about it.

Before we get to the yield curve, I want to touch on tariff talk. While my team and I continue to monitor trade relations closely, it’s the lack of agreement between the US and China that’s leading to fear – fear that this uncertainty and tariffs will lead to an economic slowdown.

This worry about the economy is the primary variable behind talk of the inverted yield curve. And, in a way, it’s becoming something of a self-fulfilling prophecy; there’s no economic slowdown now, just the impact of investors’ fear that we’ll see one.

So, what is the dreaded inverted yield curve?

In financial analysis, an inverted yield curve is the bond market’s way of flashing warning lights of a slowing US economy. More on this in a bit.

As to the basics and the numbers, a “yield curve” is a plotted line on a graph that visually shows what bonds should pay at various maturities. The left axis is interest rates, the rate gets higher as you move higher on that axis, and the bottom of the graph depicts time. One year on the left side and time increases as you move to the right of the bottom axis with 5, 10, 20, 30 years moving to the right. So, the yield curve is the graphical line you get when you plot bond yields along a timeline for one, two, five, ten and 30 years and connect the dots.

The line is supposed to slope up; you should get more interest the longer you decide to tie up your money.

For instance, 30-year yields should be higher than ten, ten higher than five, and so on down the line. Typically, we see this trend in corporate bonds, treasury bonds, and even CDs. In a “normal” world, a one-year bond would pay say 1%; a two-year bond would pay 2%, a three-year bond would pay 3%, and so forth.

An inverted yield curve is a way of describing an interest rate environment where long-term bond interest rates/payouts are lower than they are for short-term bonds. When these values get out of whack, we could head into inverted yield curve territory.

Consider now if a one-year bond pays 1%, a two-year bond pays 3%, and a three-year bond pays only 2%. This longer-term bond is yielding less than its shorter-term cousin. While this scenario is rare, this example signals something is not quite right with the economy. This is the reason we care so much about inverted yield curves, and why they are making headlines.

For more context on the predictive potential of inverted yield curves, let’s look back at some economic history.

Our data shows that five out of the last six times the yield curve has inverted, the US economy has gone into recession. So, it’s not a perfect indicator, and once inversions occur, it’s important to remember that recessions typically don’t happen right away.  In fact, it has taken 1 ½ years on average for a recession to manifest post curve inversion.

And, there has also been a false positive for the inverted yield curve recession indicator. In March of 1998 the yield curve inverted, and the US economy stayed out of recession for a full three years.  During that time, the S&P 500 posted a 16.5% gain before the next recession began in March of 2001.

Consider these data points:

  • In 1978 we inverted, and 500 days later we hit the recession of the 1980s.
  • In 1988 we inverted, and 550 days later, recession hit.
  • In 1999 we inverted, and 400 days later came recession
  • In 2005 we inverted again, and 700 days later we saw another recession.

If we average the number of days from the above, we get to a little over 540, or about one-and-a-half years that a recession struck after the yield curve inverted. That’s a very long window – a full year and a half before anything bad happens economically.

And in fact, the market usually does well in this interim period, with stocks rising an average of 15% until we enter recession territory. This is complicated for investors, but not wholly bad news. In one instance [1988 – 1990] markets were up 37% after an inverted yield curve and before we entered a recession.

Back to the present day, we’re now getting close to seeing an inverted yield curve. Today the 10-Year Yield stands at about 2.9% and the 2-Year at 2.8%, so we are about 10bps, or 1/10th of 1% away from the zero bound, or inversion. 

Now, on to a discussion of the yield curve and the economy. Here are the basics:

  • A normal or steep yield curve means the economy may start to accelerate.
  • A flat or inverted yield curve means the economy will begin to slow.
  • While it is correct to say that inverted yield curve has preceded all the recessions in the past 40 years, not all yield curve inversions have spelled recession. There has been a false positive.

With this information in mind, let’s go back to our original question and answer what an inverted yield curve means for investors. Read as: Should you take it as a sign to run for the hills and jump out of stocks?

The answer is maybe, but probably not.

Before you pack your bags, I ask you to remember that Leading Economic Indicator (LEI) growth turns negative before recessions and we’re not even close to that happening. The LEI index is showing 6% year over year growth, well within a margin of economic safety.

If the data shifts more negatively, and we decide heading for the hills seems like the prudent thing to do, how would we make that look?

In a nutshell, we would aim to further shift our asset mix to higher and higher quality components. That means fewer cyclical companies that have defensible cash flow streams along with less credit-sensitive bonds. Ultra-high-quality assets tend to underperform in a rip-roaring economy and outperform as the economy slows or heads into recession, due to their less cyclical nature.

However, for so many investors’ portfolios, they already have top tier quality companies and bonds. More aggressive portfolios can be somewhat different, but that’s generally the case for families who are just starting out, think those in their 30s and 40s.

At some point, once the economy turns around again and heads higher, we would want to find more cyclical/higher beta names that can outperform during an economic recovery.

All this to say, we are very aware of an inverted yield curve and what it means, and perhaps more importantly, what it doesn’t mean. We will be watching closely.

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