How Worried Should You Be About A Yield Curve Inversion?

by: L&F Capital Management

Financial markets are being weighed by a potential yield curve inversion.

Yield curve inversions, despite their predictive power, have historically mistimed market tops.

Following each the past three major inversions, the S&P 500 proceeded to rally in a big way in the subsequent 5 to 20 months.

The true indicator of a market top is a yield curve re-steepening after a prolonged period of being negative/flat.

Considering the yield curve still hasn't gone negative, we are still a ways off from this indicator raising a red flag.

We would like to preface this article by saying that while the analysis of markets is a multi-faceted and multi-dimensional study, this article will examine simply one of those dimensions: the yield curve and its correlation/impact on financial markets. As such, this analysis isn't the answer to the market riddle, but rather an important piece in the much larger market puzzle.

Over the past several months, the financial markets have dealt with multiple headwinds and concerns which presently leave the S&P 500 up just 2% on the year, versus a 90-year average annual gain of 10%. The most recent of these market headwinds is a potential yield curve inversion, which economists and market observers look at as a harbinger of a recession (a yield curve inversion has correctly predicted every U.S. recession since 1950).

Our research indicates that while a yield curve inversion is a harbinger of bad news for financial markets, it isn't the doomsday scenario that many market observers think it to be. During prior major yield curve inversions in the era of the digital economy (post-1985), a yield curve inversion has correctly predicted a market top, but not with perfect timing. Each time the yield curve has inverted since 1980, the S&P 500 rallied meaningfully in the several months following the inversion, and often rallied for more than a year. Instead, the true predictor seems to be when a negative 10-2 Treasury Yield Spread starts to move up, as this dynamic has correctly timed a market top in each of past three major yield curve inversions. We are not there yet, and so we do not think a potential yield curve inversion is a red flag just yet. Instead, we think our analysis supports a bull thesis on SPDR S&P 500 Trust ETF (SPY).

Chart ^SPX data by YCharts

The most recent major yield curve inversion happened in 2005. Specifically, the spread between the 10-Year Treasury Yield and the 2-Year Treasury Yield went negative in December 2005. At that time, the S&P 500 was around 1250. Over the course of 2006, the 10-2 Year Treasury Yield Spread remained largely negative, and the S&P 500 rallied. Indeed, the S&P 500 didn't peak until September 2007 at around 1550, a ~25% rise from the first time the yield curve inverted 20 months prior.

From the chart below, we can see that the market top wasn't timed by a yield curve inversion. Rather, a market top was timed by the yield curve, after being inverted for a long time, starting to re-steepen. This re-steepening happened in mid-2007, just months and few percentage points shy of the true market top.

Chart 10-2 Year Treasury Yield Spread data by YCharts

Before 2005, the previous major yield curve inversion happened in 1998-2000. The 10-2 Year Treasury Yield Spread temporarily went negative in June 1998. That sparked a big market sell-off, but that sell-off was ended by the Fed cutting interest rates in September. This normalized the curve, and stabilized markets.

Then, the curve went negative again in February 2000. At the time, the S&P 500 was trading around 1366. Markets proceeded to rally despite the inversion, and the S&P 500 didn't top out until 1520 in July. Thus, in 2000, the market rallied another 10%-plus over the 5 months following a yield curve inversion. Yet again, we see from the chart below that the true market top in mid-2000 was timed by the yield curve normalizing after going steeply negative.

Chart 10-2 Year Treasury Yield Spread data by YCharts

The other prior big inversion post-1985 happened in 1988-90. The 10-2 Treasury Yield Spread went negative in January 1989. At the time, the S&P 500 was trading below 300. Markets didn't care about the inversion. Over the next 16 months, the S&P 500 rallied another 20%-plus before its major correction in mid-1990. Importantly, we see yet again that the true market top was timed by the yield curve sharply normalizing just after July 1990.

Chart 10-2 Year Treasury Yield Spread data by YCharts

In the big picture, we draw the following conclusions from the correlation between yield curve inversions and financial market performance:

  1. A yield curve inversion, while ultimately a harbinger of slowing economic growth and financial market turmoil, does not perfectly time a market top.
  2. Usually, financial markets tend to perform well in the several months after a yield curve inversion, with the smallest gain during such time frame since 1980 being over 10%.
  3. A true market top is usually timed by an inverted yield curve sharply normalizing after being flat/inverted for a prolonged period of time.

With these conclusions, let's take a look at where we currently sit with the yield curve. The yield curve has been flattening for a while, while the S&P 500 has roared higher, but this is nothing unusual. We are on the cusp of the yield curve inverting, but history says this inversion won't be the market peak. Instead, investors should be mindful of a re-steepening of the curve after a potential inversion. This will all take several months to play out, so from where we sit, we do not think this potential inversion is a huge near term concern for markets, and believe inversion-related weakness is a buying opportunity in the SPDR S&P 500 Trust ETF.

Chart 10-2 Year Treasury Yield Spread data by YCharts

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.