What drove down US stocks this week? The answer may be the US bond market and what the shape of the yield curve is—or isn’t—telling us about the state of the economy.
For most of 2018, the US yield curve has been flattening. This happens when the gap between short- and longer-dated yields narrows, historically a sign that economic growth may be slowing.
On Tuesday, a section of the curve briefly inverted, with the yield on the five-year US Treasury note falling slightly below that on the two-year note. That helped spark a 3.2% decline in the S&P 500.
The more closely watched gap between the two- and 10-year notes was hovering at just 12 basis points, its narrowest gap since 2007. An inversion of that section of the curve, with 10-year yields falling below two-year yields, has preceded every recession since the mid-1970s. So it’s understandable why flattening yield curves cause investors to pay attention.
Current circumstances have only heightened investor concerns. The US is in one of its longest macroeconomic expansions in post-war history, and investors are growing increasingly wary that it may end soon. US growth has probably peaked this year and is expected to slow in 2019.
Meanwhile, increasing labor costs are pushing up inflation, triggering concerns that additional interest-rate hikes from the Federal Reserve could soon put an end to the current economic cycle.
Does Yield-Curve Inversion Guarantee a Recession?
Here’s something to keep in mind, though. While the US has never had a recession that wasn’t preceded by an inverted yield curve, not every curve inversion has been followed by a recession.
As the following Display shows, during the five mild inversions of the yield curve between 1986 and 2001, the US stock market returned an average of 15% in the three years following the flip, starting the month the inversion occurred. Those inversions were not followed by recession. And when the curve inverted in July 2006, it took two years for the equity market to correct.