The Inverted Yield Curve Omen

By Charlie Bilello

14 Apr 2022

There are few things investors fear more than an inverted yield curve (the relatively uncommon situation where short-term yields are higher than longer-term yields).


Because it tends to be a pretty good indicator of future economic weakness.

Case in point: the last 6 recessions in the US were all preceded by an inverted curve.

What does the yield curve look like today?

It recently inverted for the first time since August 2019, with the 2-year Treasury yield moving above the 10-year Treasury yield.

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So does that mean a recession coming?

Yes, but a recession is always coming at some point in the future. The question, of course, is when is it coming.

That’s where it gets complicated. While the average lead time from the first inversion to the start of the recession has been 19 months, we’ve seen lead times as short as 7 months (before the 2020 recession) and as long as 35 months (before the 2001 recession).

So even if past is prologue (and there’s no guarantee of that), we could be looking at a recession starting as early as November of this year or as late as March 2025 (35 months from now).

Up until now, we’ve limited our focus to the spread between 10-year and 2-year yields. Is the entire yield curve inverted?

No, and this is potentially an important point. The spread between the 10-year yield and 3-month treasury yield, one that has a longer track record than the 10-2 spread, is at its steepest level since 2017 (1.98%).

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We haven’t had a recession in the US since 1970 that hasn’t been preceded by an inversion of these two yields as well, suggesting that if and when that happens the odds of a recession would be much higher than today.

Will that happen this year?

No one knows, but since 3-month Treasury bills are highly influenced by the Fed Funds Rate, it will likely occur only after additional rate hikes. The market is currently expecting this with a Fed Funds Rate of 2.50%-2.75% at year-end (up from 0.25%-0.50% today), but even if these expectations are correct we don’t know where the 10-year yield will end up.

What about the stock market?

That’s where things get much more complicated, because a) stocks tend to top much closer to the start of recessions, and b) the stock market is not the economy.

That means stocks will often continue to rise for some period of time after the yield curve inverts. Following the last six 10-2 inversions, the S&P 500 went on to gain an additional 9% to 52% before hitting a top. And that’s only if we define an S&P 500 peak as the point from which a 20% drawdown occurs. If we allow for a greater drawdown (let’s say 25%), the examples from 1990 and 1998 (during which the S&P 500 fell slightly more than 20%) would show much larger gains (there wasn’t a >25% drawdown until the 2000-02 bear market).

While stocks do seem to exhibit below-average returns following a yield curve inversion, they are by no means an outright sell signal, as the average returns are still positive (ex: +9.7% over following year) and the percentage of positive returns are still well north of 50% (ex: 65.7% over following year).

Note: Monthly Total Returns Using 10Year minus 2-Year Spreads

The second point (stock market ≠ economy) is an important factor as well given that the stock market moves up and down for a multitude of reasons, not just the economy. Investor sentiment is a far more important driver of short-term swings in the stock market than anything else, and you don’t need a recession to cause sentiment to sour. We’ve seen this a number of times throughout history with non-recessionary bear markets, most recently in 2018.

So does all of this mean the inverted yield curve signal we just saw is meaningless?

Only if you’re using it apply precision to what is an inherently imprecise game. There is no “holy grail” indicator that can predict exactly when a recession will occur, how long it will last, and how deep it will be. And even if there was such an indicator, it would be impossible to use it in timing your exposure to the stock market.

But as a leading economic indicator, the yield curve has quite a long track record, and completely dismissing it doesn’t seem wise. I suspect that the recent inversion we’ve seen simply means that bond investors are anticipating a slowdown in economic growth. Looking at the forecasts for 1st quarter real GDP, that’s precisely what’s expected (1.1% growth via the Atlanta Fed, down from 6.9% in Q4 2021).

Whether this slowdown ultimately turns into a recession remains to be seen. But remember: a recession is always coming at some point in the future, the question is when. The yield curve may help you more than any other indicator with the odds, but it still can’t give you that answer.

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