During the tumult of global equity markets last week, brought about by rising trade tensions, a key part of the Treasury yield curve briefly inverted once again. With a flight-to-quality bid into longer duration Treasury securities, the yield on the ten-year Treasury was briefly lower than the yield on Treasury securities maturing in three months. Changes in the slope of the yield curve are driven by market expectations about the business cycle. Stronger economic growth has the tendency to increase inflation and inflation expectations, driving yields higher and bond prices down to compensate investors for the lower "real" yields. Conversely, when economic growth is weakening, you can see the yield curve flatten or even invert. Trade tensions and their impact on future growth led in part to a decline in longer-term Treasury yields.
Why is the shape of the yield curve important to Seeking Alpha readers? As graphed below, all seven domestic economic recessions in the U.S. in the last 50 years have been preceded by an inverted yield curve. There were no economic recessions in the U.S. in this 50-year plus period that were not preceded by an inverted yield curve. Understanding the information about the shape of the yield curve should factor into your portfolio construction.
An inverting yield curve is a sign that participants in a large global market - the market for U.S. Treasuries - expect lower future rates. The Expectation Hypothesis of the yield curve states that the term structure of interest rates is determined by current and future short-term interest rates plus a risk premium. When the bond market is pricing in lower interest rates in several years, it signals the fact that the bond market expects lower future Fed Funds rates. Easier monetary policy is usually conducted to support slowing economic growth.
The real economy and the stock market are naturally linked, but as investors know, they are far from one and the same. In the post-crisis era, we have seen a subnormal economic recovery, yet robust equity returns. Conversely, last year, we saw a very strong domestic economy and negative equity returns. The market is inherently forward-looking, discounting future cash flows from equities back to the present. Gross domestic product figures measure only the present. This difference in time horizons can lead to disconnects between economic growth and stock market performance.
We know that inverted yield curves mean that domestic recessions have been looming, but what has that meant for stock returns? To analyze this fact, I looked back at fifty-plus years of market history and picked the dates at which my preferred yield curve measure - the slope of the 10-year Treasury note less 3-month Treasury bills - has been negative. This can be an imprecise science, given the tendency of this slope to bounce between negative and positive before becoming more solidly negative as the business cycle matures. I tried to simply pick the most reflective date before calculating forward returns to reduce any potential bias in my data selection.
This analysis produced the chart below. After picking eleven dates at which the yield curve first inverted, I then calculated forward returns for the S&P 500 (SPY) over 3 and 6 months, as well as 1, 3, and 5-year forward periods.
Over the first three months after a yield curve inversion, returns are above trend. A three month-return of 3.4% would be above the high 2% average quarterly return that the market has delivered over long time intervals.
As that time horizon extends to six months, returns were incrementally more positive but moved below trend (3.6% versus the average semi-annual return of roughly 5% historically). Returns were also more likely to be negative than positive (six of ten observations).
As that horizon extended further to one-year returns from the point of inversions, returns remained below trend at a 5.7% average annual return. There are some strong numbers in here though - 1982, 1989, and 1998 - all produced 20%+ returns.
As the forward time horizon extended from 1 year to 3 years, forward returns remain below trend (just under 7% per annum) but pick up steam from the one-year forward returns. The strong 1998 return fades as the forward period starts to include the burst of the tech bubble. There are only two negative periods (2000 and 2006), whose forward three-year periods capture parts of the tech bubble unwind and Great Recession, respectively.
As you extend this period to five forward years, the average annual return is just over 10% annualized, roughly in line with historical equity market gains. Nine of the ten periods are positive.
Of all of the data horizons, the forward five-year horizon might be the most salient for many investors. Inverted yield curves portend recessions. Negative economic growth tends to coincide with weak equity returns over the intermediate term. While investors may have a few years of sub-trend performance, those with long investment horizons should expect that as the forward horizon extends that returns will likely be positive and rebound to historical averages.
Early signs of yield curve inversions are not necessarily negative for short-term equity returns. Returns do tend to weaken over forward 1-3-year periods. Investors should use the solid early periods after yield curves invert and the business cycle matures to continue to position their portfolios for increased likelihood of stress. Make sure your portfolio is positioned to withstand some market turbulence and consistent with your personal risk tolerance. With a well-positioned portfolio, investors can look to add into weakness. Adding risk in weakening environments can help portfolios capture the ultimate rebound that will occur as returns normalize over longer time intervals.
Disclosure: I am/we are long SPY. 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.
Additional disclosure: Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.