There are few things investors fear more than an inverted yield curve.
Why? 2 reasons…
- The last 9 recessions in the U.S. were all preceded by an inverted curve (1-yr yield higher than 10-yr yield).
Data Sources for all charts/tables herein: FRED, Bloomberg.
2. Weaker stock market returns tend to follow flat/inverted curves.
Note: yield curve range is based on (10-yr yield minus 1-year yield).
In December 2018, part of the yield inverted for the first time since 2007. At month-end, the 6-month Treasury bill yield stood at 2.56%, 5 basis points higher than the 5-year yield (2.51%).
Naturally, many investors are afraid, with 45% predicting an imminent recession in a recent poll…
Is this a reasonable expectation? Let's take a look at the last 3 times the yield curve inverted in a similar fashion (6-month higher than 5-year) after a long period with a positive slope…
1) In December 2005, the yield curve inverted for the first time since 2000. The S&P 500 ended the month at 1,248. What happened next?
- The S&P 500 continued to rally for another 22 months, rising over 26% before peaking in October 2007 at 1,576 (note: price returns, does not include dividends).
- The U.S. economic expansion continued for another 24 months before the recession began in December 2007.
2) In August 1998, the yield curve inverted for the first time since 1989. The S&P 500 ended the month at 957. What happened next?
- The S&P 500 continued to rally for another 19 months, rising over 62% before peaking in March 2000 at 1,553.
- The U.S. economic expansion continued for another 31 months before the recession began in March 2001.
3) In March 1989, the yield curve inverted for the first time since 1981. The S&P 500 ended the month at 295. What happened next?
- The S&P 500 continued to rally for another 16 months, rising over 25% before peaking in July 1990 at 369.
- The U.S. economic expansion continued for another 16 months before the recession began in July 1990.
As we can see, there is no rule saying a recession has to start immediately after an inversion. The yield curve is a long leading indicator, and in the last 3 cycles it took between 16 and 31 months after inversion for a recession to start and between 16 and 22 months for the stock market to ultimately peak.
Does it have to take that long?
No, there are no hard and fast rules in investing. Every cycle is different and just because something hasn't happened in the past doesn't mean it can't happen in the future. A recession could start next month and the stock market could have already peaked (S&P 500 ended the year at 2,506, down from its September high of 2,940). But these are possibilities, not probabilities. The more probable path based on history seems to be that the expansion will continue for at least a little while longer and stocks will recover their recent losses.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.