An article in Forbes addressed the recent inverted yield curve, utilizing commentary from Phill Nelson's blog piece.
Headlines blared when a rare anomaly occurred in the bond market. While the yield curve has been inverted in a general sense for some time, for a brief moment the yield of the 10-year Treasury dipped below the yield of the 2-year Treasury. This hasn’t happened since the depths of the 2008/2009 recession. The news was enough to cause our roller-coaster markets to suffer its worst drop this year.Does this inversion signal an impending recession, or are we merely witnessing the lemming-like behavior so typical of headline inspired trading?
Certainly, history suggests a correlation between inverted yield curves and recessions, albeit with a sometimes significant lag time.
“The timetable varies but it is generally within a 24-month period, so while it can be a very early indicator it is one that should be heeded,” says Greg McBride, chief financial analyst at Bankrate.com in Palm Beach Gardens, Florida. “The most dangerous words in finance are ‘it’s different this time.’ We’ve heard that in the past couple recessions and it hasn’t turned out to be different.”
What triggered the market fall-off, however, was the rare 10-year/2-year inversion. This specific data point has been cited as a reliable harbinger of recession.
“Research from Credit Suisse says a recession occurs 22 months after an inversion in the two-year/10-year rate curve, on average,” says Arielle O'Shea, investing and retirement specialist at NerdWallet in Charlottesville, Virginia. “But it’s worth keeping in mind that that is just a historical average, not a prediction."
But, as the SEC demands mutual funds always brandish the disclaimer “past performance does not guarantee future results,” so too must economic prognosticators be wary of coming too quick to a conclusion.
“Just because this inversion appears, it doesn’t mean we’re immediately going to have a recession,” says Linda Beck, Senior Vice President/Director, Fixed Income at Bailard in Larkspur, California. “This time may or may not be different as the US is now able to fund some of its economic growth via the globally suppressed interest rates. Central bank purchases of bonds (from the Fed’s Quantitative Easing program) is impacting the level of interest rates. Some have argued that the US Treasury yield curve might not be inverted (or as inverted) if the Fed was no longer buying bonds to retain their balance sheet.”
In addition, you need to be careful not to confuse the normal movements of the economic cycle with how the stock market might react. “Rarely does the stock market and the economy move in lock-step with one another,” says Rob Reilly, Chief Investment Officer at Sandy Cove Advisors, in Boston. “While an inverted yield curve may mean we see a recession in the next few years, that doesn’t mean it will be easy to time the markets.”
Indeed, before making any investment decisions, diligent observers attempt to read the data within the broad setting of today’s reality.
“The predictive power of this indicator requires greater context following the Federal Reserve’s unprecedented monetary accommodation during the financial crisis in 2008,” says Phillip Nelson, the Head of Asset Allocation at NEPC in Boston. “The central bank’s large balance sheet has driven Treasury term premiums to historic lows, potentially enabling more frequent yield curve inversions without the associated risk of a recession. Escalating trade tensions with China and worries of global contagion have dragged down longer-dated Treasury yields, potentially distorting the yield curve.”
One particular fact to remember is the exact nature of the event which caused the market to drop so precipitously. This is where you may benefit from understanding a bit about human psychology and the resultant behavior it may have on financial markets. Armed with this perspective, you can begin to discern whether the reports warn of a looming calamity or whether they’re mere hype for those too quick to jump on whatever band wagon happens to be rushing by at the moment.
At this point, you’d be wise to proceed with caution before reacting to current headlines. “The inversion between the 2-year and 10-year Treasury occurred only momentarily,” says Eric Kelley, EVP/Managing Director, Research at UMB Bank in Kansas City, Missouri. “It needs to stick for a few weeks before it’s a true inversion.”
Moreover, a lot of good can happen between the onset of the inverted yield curve and the economic slowdown it presages.
Nelson views the recent yield curve inversions as a part of “Late Cycle Dynamics.” “Late-cycle does not mean end of cycle as equity markets can continue to offer strong returns,” he says. “Similarly, in the year following a 10-year/2-year yield curve inversion, US equities have historically posted positive returns.”
You need look no further than the 2008/2009 recession for evidence of how the lag between the inversion and the recession can offer such an opportunity.
Jennifer Hutchins, Portfolio Manager at 1st Global in Dallas, Texas, says, “The yield curve inverted in February 2006, well before the down market swing in October 2007. If investors had pulled out of the market in February 2006, they would have missed out on approximately a 12% gain posted by the S&P 500 over the next 12 months. In fact, if investors had pulled out prior to October 14, 2007, they would have missed out on a cumulative 25% gain in the S&P from March 1, 2006 thru October 14, 2007.
Perhaps the sage advice to avoid the “this time it’s different” mindset might turn out to be quite profitable.
Time will tell.