It's true that when the five-year treasury rate dips below the two-year treasury rate it's not a good sign.
The five-year treasury rate minus two-year treasury rate is a premature signal and does not immediately signal a bear market.
The 10-year treasury rate dipping below the three-month treasury rate is the signal you should be watching.
Therefore, it is a bad idea to bet against a new all-time high in the U.S. stock market.
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The recent history of yield curve inversions
A lot of ink has been used to write about the inversion of the five-year treasury rate minus two-year treasury rate yield curve inversion. The financial media and the recent market moves seem to be getting quite jittery about the five-year minus two-year yield curve inversion as if it is signaling an imminent market crash. Let's take a little look at history to see what happened before the past three recessions:
Source: Board of Governors, St Louis Fed, Wilshire.
In the graph above, you can see the multiple treasury yield curve differentials as well as the total stock market index Vanguard Total Stock Market ETF (VTI). On the left axis is the five-year treasury rate minus two-year treasury rate in blue, the 10-year treasury rate minus two-year treasury rate in green, and the 10-year treasury rate minus three-month treasury rate in red. On the right axis on a logarithmic scale is the Wilshire 5000 (in orange) (VTI).
While the five-year minus two-year did invert before the past three recessions, it did so well before it would be a good time to get out of the market. As you can see, the blue line crosses below the black (zero) line while the orange line (VTI) keeps moving higher until we hit the shaded areas, which are recessions. By eyeballing it, you can see that the inversion happens about two or more years before the start of a recession and there is about 30% to 40% left until the peak of the bull market.
Instead of looking at the five-year treasury rate minus two-year treasury rate, we should be looking at the 10-year treasury rate minus three-month treasury rate yield curve inversion. In the graph above, the red line crosses below the black line about one month to 18 months before the local peak of the orange line (VTI). If you were to use -25 bps as the signal threshold (equivalent to one rate hike too many by the Fed), it would bring that range down to between zero months and 12 months before the peak of the stock market. But how did the 10-year minus three-month inversion work out for recessions before the 1990s, you ask? Good question!
The long-term history of the 10-year treasury rate minus three-month treasury rate
Source: Board of Governors, St Louis Fed (yields & recession). Shiller (S&P 500) 10-year treasury rate minus three-month treasury rate = 10y-3m = black line. Start and end of recessions = grey line. S&P 500 index in log scale = red line.
Pretty well, actually! We can see that the 10-year treasury rate minus three-month treasury rate (10y-3m) has inverted before every recession post 1967 except before the 1990 recession. That is different from the graph we just saw above where the 10y-3m inverted before the 1990 recession. Indeed, the 10y-3m is measured in a slightly different way on this graph (because the old way of measuring it is slightly different than the new way).
If we were to use the trough in 1989 of the 10y-3m and compare between the two graphs, we would have to bring down the values on the longer-term graph by 45 bps for values before that 1990 recession. If we were to backward-adjust in that manner the 10y-3m would have inverted before every market downturn since World War II, except for the soft patch of 1953. So the 10y-3m seems to be a very reliable indicator to indicate recessions, but also cyclical market tops.
Before the second world war the 10-year treasury rate minus three-month treasury rate yield inversion is not as reliable. This probably comes from the evolving Fed mandate, as shown in this extract from a Fed speech on the history of the Fed:
The Fed's mandate was very different before World War II, and it is only since 1978 that the Fed has had its dual mandate.
It is best to take the five-year treasury rate minus two-year treasury rate yield curve inversion with a grain of salt. While it does precede a recession, its signal is very premature. We should monitor the 10-year treasury rate minus three-month treasury rate yield differential, which has historically been a very good predictor of a coming recession and of a cyclical top in the stock market (VTI).
In addition to the 10-year treasury rate minus three-month treasury rate there are other economic indicators that can be useful to monitor. I will try to address them in a future article.
Disclosure: I am/we are long VTI. 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.