Yield Curve Inversion! Take risk off the table?

Fearful Cartoon
Written by J. Cannon Carr, Jr., Mark H. Tucker, CFA on March 31, 2019

On March 22, the yield curve began to invert, which many consider to be an indicator of recession within 12-24 months. What should we do in response? Is it time to reduce equity exposure, at least for some groups of investors?

Summary Messages:

  • Sustained inversion of the yield curve has historically done a good job of predicting recessions. The problem is, when it comes to stocks and investing, investors can only see the clear signal in hindsight.
  • Selling stocks while trying to interpret the yield curve is more likely to hurt returns than to help them. Stocks typically rebound much more quickly than investors—both professional and recreational—can react. Missing those days can damage performance materially.
  • Instead, investors should develop an investment plan that accommodates all phases of the business cycle, including recession. Understanding time horizons is key.

First off: what does “inversion” mean and how does it happen?

Most of the time, when expectations for economic growth are good, long-term government bond yields are higher than short-term yields. The “yield curve” slopes upward. Why? Because long-term bond investors must be compensated for the risk of inflation, which can chip away at the value of the bond over time. That’s why you usually get higher yields on a 10-year government note than you do on one that pays you back sooner. For reference, see the curve for a year ago (in yellow) in Exhibit 1.

Exhibit 1: Yield Curves at Various Dates

Recent Yield Curves

source: Bloomberg and CornerCap

What happens if the economic outlook dims? The dynamics driving the yield curve are notoriously complex, but to simplify: longer-term rates tend to fall as investors seek safety and bid up government bond prices. At the same time, the Fed might be increasing short-term rates as a matter of policy. This was happening last year, and the yield curve began to flatten out (see the gray curve for year-end 2018, Exhibit 1).

Inversion means that long-term yields are lower than shorter-term yields. The yield curve moves beyond flat; it slopes downward. This condition occurs typically later in the business cycle, as monetary policy has run its course (the Fed has raised short-term rates) and investors are pessimistic about the future. See the most current curve (in crimson), Exhibit 1.

Notably, inversion has presently occurred for 3-month yields vs. 10-year yields; it is flat for 1-year vs. 10-year; and upward sloped for 2-year vs. 10-year. Each is important, and they are not yet conclusive.

 Does Inversion Foretell Recession?

Inversion doesn’t occur often—ten times since 1955, using the 1-year vs. 10-year spread on US Treasury Notes. Historical research shows that sustained inversion is highly predictive of recession (Exhibit 2), whereby it has preceded negative economic growth in nine of those instances. Recession occurred within 6 and 24 months of inversion.

Exhibit 2: Timing of Inversion and Recession

source: The Federal Reserve Board of San Francisco Economic Letter 2018

Note: This analysis looks at the difference between 1-Year and 10-Year Treasury yields.

 

Some observers point out that the Fed’s policies over the past ten years might nullify these “predictive powers.”[1] The Fed has clearly warped yield curve dynamics, in our view; long-term yields are arguably artificially low vs. historical standards after their aggressive policies.

Still, we would not discount the historical relationship between inversion and recession. From a practical perspective, banks make lending decisions according to the yield curve. When it is inverted, banks have less incentive to lend, which puts risk to economic growth and reinforces investor pessimism.

We should also point out that many key leading economic indicators are not yet flashing red. The Conference Board, for example, tracks ten indicators[2] (one of which is inverted spreads) often expected to predict economic trends, with encouraging conclusions as of today. So there is arguably legitimate counter-evidence.

What Should Investors Do When the Curve Inverts?

The answer starts with understanding two key concepts:

  • Yield curve inversion may be one of the better predictors of recession available, but it is unfolding dynamically in unpredictable ways. A flat curve does not reliably predict recession, and an inverted curve over short periods does not tend to, either. Inversion must persist for enough time. Combine this dynamic with the Fed’s ability to influence the curve, and you get real-time, unpredictable influences on the yield curve. In our view, it sends a clear, predictive signal only in hindsight.
  • The best returns from stocks occur only from a very limited number of days. See Exhibit 3. Think about it. If you decide to exit the market, and miss the best 50 days over the past 20 years (less than 1% of all trading days!),  your returns drop dramatically from 6% per year to -6% per year. How do you know which days matter? You can’t know. Timing the market doesn’t work.

Exhibit 3: The Cost of Market Timing

The Cost of Market Timingsource: Morningstar and CornerCap

So, for most investors, the best approach is to recognize that recessions are inevitable and it is difficult to effectively and reliably side-step them. If you try to, and you are off on your timing, you are likely to jeopardize performance in a material way.

Instead, investors should:

  • Assess their investment horizon and risk profile (comfort with volatility)
  • Consider near-term and long-term goals (anticipated cash needs vs. future growth)
  • Develop an appropriately diversified portfolio to balance these various forces
  • Stick with their investment plan, once it is set—with periodic appraisals and updates to the first three bullets above.

Understanding Time Horizons is Important

For perspective, we point out that an investment plan must reflect the specific goals and time horizons of each investor:

  • Investors with long horizons can navigate through economic hard times with the proper risk profile. Importantly, they should stick to their spending policies during those hard times so they don’t jeopardize long-term performance.
  • By comparison, for investors with nearer-term horizons, economic downturns present  a greater threat. This is why a more conservative portfolio mix of investments are typically more appropriate.

If you have questions regarding your profile relative to the economic environment, please give us a call.

Final Point: How Do Stocks Perform after Inversion?

Since stocks are forward-looking, it may come as no surprise that they often react negatively to inversion initially (but not always), and generally recover in a reasonable timeframe.

We reviewed the performance of stocks after inversion (defined by comparing the 1- and 10-year yields) since 1965. Where possible, we focused on those dates where inversion began to persist (e.g., lasting for at least two or three months), and then we mapped the returns of the S&P 500 for the ensuing 3- months, 6-months, 1-year, 2-year and 5-year periods.

Over the seven recessions, two did not post negative returns for any period (1980 and 1990 recessions). One—the dot-com recession in 2001—posted negative returns for all but the 3-month period. And the others (recessions of 1969, 1973, 1981, and 2007) followed a broad pattern of initial weakness and eventual recovery (within 6 months to two years for all but one, which needed more than two years).

Based on this analysis, it is clear to us that investors cannot use inversion to determine a strategy for stocks.

Incidentally, we also reviewed the performance of stocks before and after recessions in a recent commentary, underscoring that stocks tend to recover long before a recession is officially announced. Here’s the link for reference: http://www.cornercap.com/blog/do-stocks-do-worst-or-during-recession.

Bottom Line

A sustained inverted yield curve is a cause for concern. While it sends a clear signal only in hindsight, we believe it does point to an increased risk of recession in the next two years.

Taking “risk” off the table by reducing equities is not an appropriate response, however, for most investor groups. There is high risk of misinterpreting signals that are only clear in hindsight, and while exiting the market may feel comfortable near-term, the decision to re-enter the market is often difficult.

Most importantly, the downside risk of being “out of the market”— i.e., deviating from your long-term investment goals—is high, considering that returns are earned from less than 1% of trading days. Stocks are forward-looking and are likely to rebound when you least expect it.




[1] Recall that since the financial crisis of 2008, the Fed has influenced both the short-term yields (by raising overnight bank lending rates) and long-term yields (by purchasing bonds under the “QE” approach).

[2] Their indicators for the US include: average weekly hours (manufacturing); average weekly initial claims for unemployment insurance; manufacturers’ new orders (various industries), ISM Index of New Orders; building permits (new private housing units); stock prices (S&P 500); Leading Credit Index;  interest rate spreads (10-year Treasury bonds less federal funds); and average consumer expectations for business conditions.

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