Most investors may be surprised to know that historically the 10-Yr/2-Yr and 10-Yr/3-Mo yield curve spreads tend to invert in tandem. Specifically, until this business cycle, the 10-Yr/2-Yr spread has consistently inverted prior to the 10-yr/3-Mo. This relationship goes back to the 1970s when 2-year Treasuries were first auctioned regularly.
Currently, the fact that the 10-Yr/2-Yr yield curve has not inverted prior to the 10-Yr/3-Mo is a bit of a puzzle. There are any number of articles providing some thoughtful analysis of the current 10-Yr/3/Mo inversion. Several authors/experts suggest that there are factors other than a looming recession that may have caused the inversion, including the trade wars and distortions due to the policies of central banks (for example, read here).
Whatever the reasons might be, understanding the historical record of yield curve inversions can help investors gauge the importance of the current 10-Yr/3-Mo inversion. Accordingly, this article will look at how the 10-Yr/2-Yr and 10-Yr/3-Mo inversions have unfolded and preceded recessions and stock market peaks.
Why the 10-Yr/2Yr and 10-Yr/3-Mo yield curves?
According to the Fed, the 10-Yr/2-Yr and 10-Yr/3-Mo curves provide useful economic and monetary signals. In an article in the San Francisco Fed newsletter, titled Information in the Yield Curve About Future Recessions, the authors, Michael D. Bauer and Thomas M. Mertens, state that following the 10-yr/2-yr spread is often preferred “because the former summarizes long-term perceptions and sentiment of bond market investors, while the latter is viewed as a reasonable indicator of the stance of monetary policy.” The article also notes that the 10-yr/3-mo term spread has “strong predictive power of... recessions and economic activity” and is the preferred measure used in academic research. For this reason, the 10-yr/3-mo inversion tends to be used as a recession marker.
Comparison of 10-Yr/2-Yr and 10-yr/3-Mo Yield Curves
To show the relationship between both yield curve spreads, a comparison will be made of 1) the date the yield curves first inverted, which generally have had brief durations, and 2) the date of the first extended inversion lasting at least 30 days. The first inversion, even if it is brief, is notable because it is the advanced notice of financial stress in the bond markets. And, the first extended inversion is also important because it has historically been used as the recession marker.
For this analysis, I’m using daily yields because in real time we become aware of and track yield curve inversions by the day. Using historic daily spreads helps to put the recent inversions in context with previous ones.
1975-1980 and 1980-1981: First business cycles with the 10-Yr/2-Yr yield curve
As mentioned earlier, 2-year Treasuries were regularly auctioned beginning in the 1970s. Consequently, the 1975–1980 business cycle is the first in which the 10-Yr/2-Yr and 10-Yr/3-Mo yield curves can be compared. As a bonus, Chart 1 also includes the short 1980-1981 business cycle. During both business cycles, the 10-Yr/2-Yr (orange) inversion preceded the 10-Yr/3-Mo (blue). As I will show, this pattern of the 10-Yr/2-Yr inverting first is consistent with other business cycles until now.
Table 1 provides details about the inversions. During the 1975-1980 business cycle, the 10-Yr/2-Yr first inverted on August 8, 1978, 16 months prior to the recession. It remained inverted until the recession was well underway. The 10-Yr/3-Mo had a brief inversion on November 1, 1978, for 2 days, which was followed by several other brief inversions. On December 15, 1978, 12 and 1/2 months prior to the recession, the 10-Yr/3-Mo began an extended inversion that continued into the recession.
During the 1980-1981 business cycle (bottom row of Table 1), the first inversions for both the 10-Yr/2-Yr and 10-Yr/3-Mo were, respectively, 409 and 95 days. Here, again, the 10-Yr/2-Yr inverted first, about a month and a half before the 10-Yr/3-Mo.
Inversions during 1982–1990 business cycle
Chart 2 shows the intertwined relationship between the 10-Yr/2-Yr and 10-Yr/3-Mo inversions during the 1982-1990 business cycle. The yield curve inversions, brief and extended, occurred over a five-month period, with the spreads switching several times between negative and positive.
Inversions are not one-time events that definitively predict when a recession will begin. During the 1982-1990 business cycle, there were eight 10-Yr/2-Yr inversions of one or more days and eight 10-Yr/3-mo inversions of one or more days. When you hear that a recession occurred x number of months after a yield curve inversion, generally, that duration is from the beginning of the first extended inversions that last 30 days or more.
Chart 2 Table 2 shows that the 10-Yr/2-Yr first inverted on December 13, 1988, for 9 days, and the 10-Yr-3-Mo inverted later on March 27, 1989, for 1 day. The pattern of the 10-Yr/3-Mo leading the 10-Yr/3-Mo continues with the first extended 10-Yr/2-Yr inversion beginning on January 4, 1989 and lasting for 123 days. The first extended inversion for the 10-Yr/3-Mo occurred on May 24, 1989, lasting 30 days. For both inversion events in Table 1, the 10-Yr/2-Yr preceded the 10-Yr/3-Mo. Also, the pattern of initial, brief inversions leading extended inversions continues in later business cycles.
Most articles or research papers use the May 24, 1989 10-Yr/3-Mo 30-day inversion as the recession signal. You will often read that the 1990-1991 recession occurred 13 months after the yield curve inverted.
Inversions during 1991–2001 business cycle
As shown in Chart 3, the initial inversion during this business cycle is unique because it occurred early. The 10-Yr/2-Yr inverted nearly 33 months before the recession, and the 10-Yr/3-Mo nearly 30 months prior to the recession (I address the reasons for this in this article - briefly, the Fed raised rates and the economy stalled). After a few more brief inversions, the 10-Yr/2-Yr yield curve didn't invert again until February 2000, 13 months prior to the recession.
Table 3 confirms the continuing pattern of the 10-Yr/2-Yr inverting prior to the 10-Yr/3-Mo. The first inversion of the 10-Yr/2-Yr occurred on June 9, 1998, lasting for 22 days. The first inversion of the 10-Yr/3-Mo wasn't until September 10, 1998. The 10-Yr/2-Yr began an extended inversion on February 11, 2000, 13 months prior to the recession. The extended inversion for the 10-Yr/3-Mo didn’t occur until July 7, 2000, eight months before the recession.
The 10-Yr/3-Mo spread that started on July 7, 2000 is generally used as the recession indicator. Hence, it is generally reported that the 2001 recession started 8 months after the yield curve inverted.
Inversions during 2001–2007 business cycle
Chart 4 shows similar patterns to the previous charts. Although the inversions are unique to each business cycle, there is remarkable consistency, with brief inversions being followed by extended ones.
Although Table 4 shows a similar pattern of the 10-Yr/2-Yr leading the 10-Yr/3-Mo, one difference is how close the inversions are. The first inversion of the 10-Yr/2-Yr occurred on December 27, 2005. The 10-Yr/3-Mo spread inverted about two months later on February 22, 2006. The extended inversion for the 10-Yr/2-Yr began on June 8, 2006, nearly 18 months before the recession. The extended 10-Yr/3-Mo inversion began on July 19, 2006, 16 and 1/2 months prior to the recession.
Table 5 shows how unusual the current 10-Yr/3-Mo inversion is. There has been both a brief, initial inversion and an extended one that has surpassed 30 days without the 10-Yr/2-Yr inverting. Using the Month from Recession ranges found on the above tables, this could suggest that a recession is between eight to 17 months away. Yet, as I have already noted, numerous articles suggest that unique factors specific to this business cycle may be leading to an inversion that is not signalling a recession within the expected time frame.
Obviously, each business cycle is unique and how the yield curve inversions play out will be somewhat different. However, it seems notable that until the current business cycle, the 10-Yr/2-Yr has always inverted first. The fact that the 10-Yr/2-Yr has not inverted should not be dismissed as irrelevant.
Stock market returns after extended 10-Yr/3-Mo inversions
In an earlier article, I made the point that normal yield curve inversions not only precede and signal recessions, but also occur before stock market peaks (last paragraph of this article). Using the extended 10-Yr/3-Mo inversion events from tables 1, 2, 3, and 4, in Table 6, I’m showing the value of the S&P 500 on the date of the inversion, what it was when the index peaked, and how soon the market peaked after the inversion date.
During the 1975-1980 business cycle (A), the stock market didn't peak until one month after the recession began. I guess the recession snuck up on investors. The 1991–2001 business cycle data (C) is skewed due to the dot-com bubble. During that business cycle the market peaked earlier than is normal, seven months prior to the recession. During the 2001–2007 business cycle (D), the market peaked just two months before the recession, while, as shown in Table 3, the 10-Yr/3-Mo curve inverted 17 months prior to the recession. Hence, the market had a fairly lengthy run from the inversion date until the market peak.
What is clear from Table 6 is that the market moves to its peak after the 10-Yr/3-Mo inverts.
If the current 10-Yr/3-Mo inversion is signalling a recession, as Table 6 indicates, history says that the stock market is likely to continue upward in the near future. If the inversion is due to something other than pre-recession factors, then it seems likely that the market is likely to also move to a new high.
Is a recession imminent?
The inversion of the 10-Yr/3-Mo spread indicates distress about near-term economic growth. This should not be dismissed lightly. Yet, investors are willing to hold 2-year Treasury notes, which counters the case for a recession.
Despite some weakening, recent economic activity and outlook remain relatively strong, as shown in the current BaR Analysis Grid© (Grid 1). The MoC, mean of coordinates, is still well above the baseline (recession indicator). In fact, none of the 19 economic indicators that are tracked are approaching the baseline. If you are not familiar with the BaR, you can read about it here.
Of course, this could change. Prior to the last two recessions, the MoC dropped rapidly during the last year. If everything did begin to unravel, with the MoC currently at 29% above the baseline, the MoC could plausibly move into the recession zone within a year and a half. However, there are many ifs. For example, if the Fed responds with interest rate cuts, the economy could plod along for a much longer period of time.
A case can be made that the current 10-Yr/3-Mo inversion may not be the same type of recession indicator as when the 10-Yr/2-Yr has inverted. Yet, by itself, a 10-Yr/3-Mo inversion indicates financial stress and it can only weaken the economy. At this point, a reasonable strategy is to diligently follow critical economic indicators and adjust portfolios as the likelihood of a recession, or not, becomes clearer.
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.