This morning, the spread between the yields on the 10-year and 2-year Treasury bonds went negative. This situation is called “yield-curve inversion”, and it has been a very good predictor of recessions over the past several decades. In fact, there has only been one time in the past 50 years in which an inverted yield curve was not followed by a recession. That particular instance would be called a “false positive.” But this time around, the evidence is starting to accumulate and become fairly compelling for more than a few investors. The spread between the yields on the 3-month Treasury bill and the 10-year Treasury note – an even more reliable predictor of a future recession – first went negative in March and now stands at -0.37%. Also, the yield on the 30-year Treasury note reached all-time low this week. Recession or not, it’s fair to say that longer-term bond yields usually don’t drop so precipitously unless there are concerns about future growth.
The last time the yield curve was inverted was in 2007, so investors are very anxious about the possible implications this time around. However, there is usually a good bit of time between yield-curve inversions and the start of recessions. According to Briefing.com, “In the five recessions since 1980, the time between the first inversion and the start of the recession has averaged just over 18 months, with a range that spans ten months to two years.” A recent Reuters article also points out that, “A yield curve inversion does not predict the length nor severity of a downturn.” Investors could be further emboldened by the fact that the yield curve has typically normalized (ie, become un-inverted) prior to the start of the recession. With regard to stock prices, investors are generally slow to react to yield-curve inversions as well. An article on CNBC.com today cites Credit Suisse data, saying that “It’s not until about 18 months after an inversion when the stock market usually turns and posts negative returns.” This is all to say that investors may have a good deal of time before they have to worry about a meaningful correction in stock prices. It’s quite possible that these lags are reasonable justification to be hopeful in the face of the bond market’s warning signs.
There is also hope that policymakers may be able to forestall the demise of both the economy and stock market. Specifically, the Federal Reserve could step in to cut rates at any time, perhaps even following an emergency intra-meeting decision. In a July 2018 presentation, St. Louis Fed Chair James Bullard said, “Yield curve inversion is a naturally bearish signal for the economy. This deserves market and policymaker attention.” As well, there is always the possibility of a sudden and definitive resolution to the trade war with China. Finally, one would be wise to remember that there is an election next year. It makes sense to assume that policy stimulus would be put in place to ensure that the economy stays out of trouble before that date. Some investors believe that the levers are clearly available, but we just need someone to pull them.
It is also true that the yield curve flattening, which has finally culminated in inversion (from 2- to 10-year), may not be an indicator of a coming recession. In the same July, 2018 presentation, James Bullard said, “To be sure, yield curve information in not infallible, and inversion could be driven by other factors unrelated to future macroeconomic performance.” Bullard is most likely referring to the large gap between yields on US debt and that of other developed nations, like Germany and Japan. In addition, the Fed’s Quantitative Easing, which effectively took trillions of dollars in Treasury bonds out of circulation, could have artificially depressed bond yields as well. Technical factors like these could certainly account for at least some of the seemingly insatiable demand (and falling yields) for longer-term US Treasuries. And relatively high yields on US Treasuries have contributed to a surge in the dollar, which is deflationary and can act as a drag on domestic economic growth. The effects of a strengthening dollar have clearly affected yields on longer-term Treasuries.
So should stock investors be confident that today’s yield curve inversion represents the end of the party for stocks? Perhaps, and perhaps not. Some may believe that the failure to heed warning signs could harken back to former Citigroup CEO’s comments in 2007: “But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” I don’t think it’s that simple. Our consistent advice has been that there are far too many variables to be able to accurately predict how the economy – much less the stock market – will unfold in the coming months and years. Many studies have shown that going to cash and missing out on just a few of the best-performing days for the stock market can cause serious damage to long-term investment returns. We advise against it.