Key Points

  • The most commonly-watched yield curve inverted last Friday, unleashing a near-2% decline for U.S. stocks; while the Fed’s preferred recession predictor yield curve has been inverted for much of the first quarter so far.

  • History paints a mixed picture of yield curve inversions in terms of both duration to recessions and stock market returns.

  • Stocks have historically lost money on an annualized basis when the yield curve’s been inverted.

Investors developed a case of the blues on Friday when the yield curve went into the red; but the history around yield curve inversions shows a wide swath of grey area. For the first time since mid-2007, the 10-year to three-month (10y-3m) portion of the U.S. Treasury yield curve inverted last Friday; which unleashed a near-2% decline in the S&P 500 on heightened fears of recession. That’s the longest stretch of time since at least the early-1960s without an inversion.

Every recession since the mid-1960s has been preceded by an inverted yield curve, so it’s little wonder recession fears have elevated. However, in addition to there having been “false positives,” an inversion doesn’t help define either the length of runway between the inversion and the subsequent recession; or the severity of the recession (or attendant bear market).

Lead-in

First, let’s dissect the lead-in to Friday’s inversion. Last Wednesday brought the Federal Open Market Committee (FOMC) decision to keep rate hikes on hold; with a definitive plan to halt the shrinking of the Federal Reserve’s balance sheet—the latter reinforcing the dovish 180 degree turn the Fed has taken since it last raised rates in December 2018. But weak U.S. economic data also aided the inversion by contributing to the decline in longer-term Treasury yields. In particular, Friday brought weaker Purchasing Managers Index (PMI) readings out of both the United States and Germany. This led to the market pricing in the end of the Fed’s rate hike cycle and that the next move will be a rate cut (about a 60% probability according to Bloomberg).

From last year’s second quarter real gross domestic product (GDP) growth rate of more than 4%, we are now looking at a fairly anemic growth rate expectation of 1.2% as per the widely-watched Atlanta Fed’s GDPNow forecast (caveat: that forecast was as low as 0.2% as recently as two weeks ago). Concurrently, global growth has weakened; with the negative interest rate policies of the European Central Bank (ECB) and Bank of Japan (BoJ) also contributing to the inversion of the U.S. yield curve. This is because low (and/or negative) yields outside the United States make U.S. Treasury bonds more attractive; and that buying pressure causes Treasury prices to rise and yields to fall.

The relationship between yield curve inversions and the economy is well known. When shorter-term rates are below longer-term rates (a normal curve), banks can lend profitably as they earn the spread by borrowing at the short end and lending at the long end. But once the curve inverts, the absence of profitability leads to compressed lending; with the resultant tightening in credit conditions contributing to a recession.