Ignore The Highly Anticipated Yield Curve Inversion

Jan. 09, 2019 10:26 AM ETDIA, QQQ, SPY6 Comments
Simrit Jhita profile picture
Simrit Jhita
41 Followers

Summary

  • Some claim the yield curve has accurately predicted market downturns and recessions in the past.
  • Investors may assume a yield curve inversion alone is a good indicator to exit equities.
  • I looked at whether a negative ten and two-year treasury spread has resulted in additional risks for the Dow Jones Index between 1976 and 2016.
  • An inverted yield curve did not translate to higher forward drawdowns or historical volatility, nor did it result in negative average returns.

Call to Action

Investors should use caution before implementing claims on television about the yield curve. Binary decisions solely made on the shape of the yield curve have not mitigated volatility and drawdowns in the past. Even if past decisions based on the inversion of the yield curve did lead to risk mitigation, this should not be expected on a forward basis due to its popularity and lack of consistency in other countries.

Yield Curve Overview

The yield curve spread is usually defined as the difference between the two and ten-year treasury yields. If the difference between the ten and two-year is negative, then the yield curve is inverted. A positive difference between the ten and two-year is normal. It is said that an inverted yield curve is a leading indicator of recessions with previous yield curve inversions not always leading to recessions, but every recession has had a yield curve inversion precede it.

Source: FRED Economic Data

The historical pattern is that the yield curve will invert, return to a normal shape after the Fed indicates cutting rates, and then the economy will enter a recession within the next couple of years. Based on this pattern, an investor might think that an inverted yield curve alone should signal higher forward risks than a normal yield curve in terms of volatility, drawdowns, and negative market returns compared to a normal curve, but this is not the case for the Dow Jones index.

Calculations Overview

I averaged forward drawdowns, realized 1-month volatility, and returns on one, two, and five-year periods for each trading day from 1976 to 2016 based on the previous day’s yield curve. I then separated these metrics into periods where the ten and two-year treasury spread (yield curve) had a negative or flat spread (inverted curve) and where the spread was positive (normal curve). This means that the average

This article was written by

Simrit Jhita profile picture
41 Followers
Simrit has a strong understanding of top-down analysis, equity valuation, and commodities. He has experience trading and investing his personal money, as a commodities trading intern, and as an investment intern. Simrit has been a Contributing Analyst on Seeking Alpha since April of 2016.

Disclosure: I am/we are long VTI, ITOT, and SPTM. 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.

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