Yield curve inversion
Equity markets and the real economy
| 29 Aug 2019
The recent ‘inversion’ of the US Treasury yield curve has led to much hand wringing from investors and the financial press alike. Inversion means that the 10-year yield is actually lower than the 2-year yield, in contrast to a normal, ‘healthy’ upward-sloping yield curve.
The brouhaha is to some extent justified, since yield curve inversion has historically been a reliable indicator of a coming recession. In fact, if we exclude the very shallow and transitory inversions of 1973, 1975, and 1998, it has never sent a false positive. So far, it is too early to say if we are witnessing a “true” curve inversion or merely a blip as on those three occasions.
That said, our preferred measure, which compares the 10-year rate with the 3-month rate (rather than the 2-year rate), first briefly inverted as long ago as March and now stands at a more deeply inverted, and therefore troubling, level of -0.35%. Typically, the curve can invert by up to 1% although prior to recent recessions it has been somewhat less than that.
Should we be heading for the lifeboats?
Not necessarily. Prompt easing action from the Federal Reserve (along the lines of its ‘mid-cycle’ interventions in 1995 and 1998) may yet ward off disaster. The US has thus far proven resilient to the global malaise, which is concentrated in the tradable goods sector upon which the likes of China, Japan, Korea, Taiwan and the Eurozone are relatively more reliant for growth.
Even if we ultimately fail to avoid recession, it does not mean that the curve inversion is an immediately sell signal for stocks. It just means that we are in the “late cycle” stage. The end of the cycle only actually arrives when the curve dis-inverts and begins to steepen rapidly. This is caused by short-end rates declining much more rapidly than long-end rates as investors anticipate an imminent and sharp monetary policy easing cycle in the face of a rapidly darkening economic outlook. The recession of 2007-09 provides a good example:
- December 2005-January 2006: US yield curve inverts
- May 2007: yield curve slope turns positive and curve “bull steepens” rapidly
- October 2007: S&P 500 makes cycle high
- December 2007: start of US recession
Clearly, those who had sold stocks in early 2006 in response to the yield curve inversion would have experienced a very painful period of nearly two years as US equities proceeded to advance another 25% before finally topping out.
So when should you sell?
The conclusion is that one should wait to see ‘the whites of the eyes’ of the recession before deciding to move to a meaningful underweight in stocks. Last time around this was arguably when the yield curve slope turned positive again in May 2007, and indeed the US stock market made a local high in June before plunging in August as the so-called ‘credit crunch’ took hold.
Prompt Fed easing caused a last hurrah in stocks, which briefly took them to fresh highs in October, but by then it was apparent what damage had been inflicted on the real economy and thus we entered the bear market that would take global equities down by 60% before they finally found a bottom in March 2009.
Today, there are relatively few signs of the kind of froth in the real economy that preceded the last downturn. Corporate leverage is often cited as a concern, although given interest rates are much lower than in the past and likely to remain so, coverage ratios are reasonable and corporates hence able to sustain a higher degree of indebtedness than was possible in the past.
If a recession does materialise, then, it would likely be relatively mild given the lack of gross excess in the period leading up to it. Most likely the accompanying equity bear market would be commensurately mild (of the order of 20-30% rather than 50-60%), but still large enough to provide opportunities for gain from asset allocation (re-allocating from equities to havens like government bonds, gold, and currencies like the US dollar, Swiss franc and Japanese yen).
Either way, global equities are likely to keep grinding higher for a little while yet.
These are the views of the author at time of publication and this does not constitute a recommendation to buy or sell any security. The information in this article does not qualify as an investment recommendation or investment advice.