- Michael Livian, CFA and Martin Fridson, CFA
What a Yield Curve Inversion Really Means
The changing relationship between short- and long-maturity U.S. Treasury bond yields is once again a hot topic. As the yield curve flattens, analysts are starting to warn about a possible recession. So, what implications does the yield curve really have for equity and fixed income returns?
Positive, Inverted, and Flat Yield Curve
At most times, long-maturity Treasury bonds offer higher yields than their short-maturity counterparts. This pattern is called an upward sloping, normal or positive yield curve. One explanation that economists provide for it is that when lenders are optimistic about the economic outlook, which is valid at most times, they expect rising demand for capital to exert upward pressure on interest rates. Under those conditions, lenders are averse to locking up their money at prevailing rates and potentially missing out on the opportunity to lend at higher rates in subsequent years. Accordingly, they demand a premium rate to commit their capital for periods stretching several years into the future.
Similarly, the relatively rare instances in which short-term rates exceed long-term rates, known as yield curve inversions, reflect pessimism about the economic outlook. Anticipating reduced demand for debt capital and hence lower interest rates in the future, lenders strive to lock in prevailing interest rates for extended periods. The resulting increase in credit supply in the longer maturities drives those yields to levels lower than the short-term rates.
Suppose investors’ expectations regarding future interest rates are invariably accurate. In that case, a yield curve inversion must be a reliable harbinger of lower interest rates and, by extension, poor economic conditions: a recession. This logical thought process has given rise to the intense focus on the fact that the yield curve, as measured by the 10-year Treasury yield minus the 2-year Treasury yield, declined from 1.24% on September 30, 2021, to just 0.19% on March 25, 2022.
Because the difference is still greater than zero, the change does not qualify as an inversion. Instead, it constitutes a flattening. Market pundits are not way out of order, however, to predict that the shrinkage of the 2-versus-10-year yield differential will continue until the yield curve inverts, which in their view would signal an oncoming recession. The prospect of a recession would probably, in turn, trigger a bear market for stocks, as well as corporate bonds and preferred shares.
The Yield Curve Predicted 13 of the last 6 Recessions
Calling for a recession and a sharp drop in securities prices solely based on a flattening yield curve is too great a leap of logic.
Flattening is not inversion. To begin with, since 1988 there have been three incidences of yield-curve flattening that began and ended with 2-to-10-year differentials very similar to those of September 30, 2021, and March 25, 2022. Each time, the S&P 500 was higher at the end than at the beginning of the yield curve flattening, as has been the case in the current episode. Furthermore, in two instances, the market judged speculative-grade bonds to be less risky at the end of the flattening than at the beginning. In the other case, the market’s perception of increased risk (indicated by an increase in the yield premium over Treasury bonds) approximately matched what has occurred during the current flattening. None of this evidence concludes that securities prices are currently out of line with prevailing financial conditions and are therefore poised to collapse.
But what if the 2-to-10-year yield differential does continue to shrink until it turns negative? That’s still not a reason to panic. The yield curve isn’t the only signal to watch for in anticipating recessions, although it is important.
Different versions of the yield curve. A different version of the yield curve (considered by some at the Federal Reserve the most predictive one), the 10-year minus the 3-month yield , is one of 10 components of the Conference Board’s Index of Leading Economic Indicators (LEI). Other components include the average workweek, new orders for capital goods, money supply, and residential building permits. LEI has posted a good record of predicting recessions, but only when it has fallen below zero. In the latest reported month, February 2022, LEI was down from an April 2021 peak of 12.3, but still safely in positive territory at 7.6, up from 7.2 in January. At the present time, the difference between the 10-year and 3-month government bond yields stands at 1.88% and is still abundantly positive.
Yield curve inversions do not translate into recession immediately.
Lead time to recessions. With so many other factors affecting the economy, the delay between the yield curve’s inversion and the commencement of a recession has sometimes been quite lengthy (6 to 18 months). For example, the 2-to-10 curve turned negative in January 1989, yet the next economic downturn did not begin until August 1990. In-between those months, the S&P 500 rose by 19% (through December 1990). The lesson is that investors who react in a kneejerk way to a yield curve inversion may miss out on excellent returns over several quarters before a recession-related bear market begins.
Also, note that negative yield curves often return to positive without a recession commencing in the interim. Based on monthly data since January 1977, the 2-to-10 curve has inverted 13 times, but there have been only six recessions in that period. To paraphrase the economist Paul Samuelson, the Treasury yield curve has predicted 13 out of the last six recessions. This is even more reason to look for confirmation from other economic indicators instead of assuming that a yield curve inversion means a recession-induced bear market is certain to follow in short order.
Over the past six months, short-term Treasury yields have risen relative to long-term Treasury yields. That trend has a not entirely undeserved reputation as a yellow flag for recession.
However, a closer look at the record tells us that it could prove a costly mistake to dump stocks and higher-yielding income instruments solely in response to this indicator.
Based on historical evidence, investors should ignore a yield curve flattening. Instead, a yield curve inversion should be considered a critical yellow flag and prompt rational portfolio adjustments, but nothing more than that.