Three different producers contacted me about the following headline, which appeared last week in the Wall Street Journal: “Inverted Yield Curve Is Telling Investors What They Already Know.” You may be forgiven for that case of déjà vu, because we last discussed the inverted yield curve in December. Here’s a refresher from my post on the topic:
Typically, it should cost less to borrow for shorter periods of time than longer ones. In the case of government bonds, when you buy a ten-year, the interest rate is normally higher than when you buy a two-year (the difference between those two interest rates is known as the “spread”). The reason is that lots of things can happen in the future, so bond buyers usually demand higher interest rates to compensate them for the additional risk of the longer time period.
A normal yield curve will slope upwards, and the steeper the slope, the more that investors think that growth, inflation and interest rates will be increasing in the future. When investors believe that the economy is slowing and that the rate of inflation will be tepid in the future, the yield curve flattens out. When short-term interest rates are higher than long-term rates, the yield curve inverts, meaning that it slopes downward.
The reason three producers asked about the yield curve last week is not because they care about the bond market, but because every U.S. recession for the past 60 years followed an inverted yield curve. So when on Friday March 22, the yield on the 10-year Treasury fell below the yield of the three-month bill for the first time since 2007, the impending doom of a recession headlines cropped up.
A few things to remember before you take cover and start to panic: YOU ALREADY KNOW THAT GROWTH HAS SLOWED DOWN! And eventually, the economy will shrink and (gasp!) go into a recession, as it does on a periodic basis. An inversion does not start some sort of count down clock. Sometimes a recession follows an inversion a few months later, sometimes it takes a year or two, and sometimes the much-ballyhooed recession does not appear at all after the curve inverts. One more thing: The curve needs to remain inverted for a while, “on average over a quarter to provide a solid signal, not just for a few days.”
What about the stock market? Glad you asked because while you were gnashing your teeth about filing taxes, U.S. stocks marched higher in the first quarter of the year. In fact, it was the best performance in nearly a decade for the S&P 500, with all 11 sectors ending higher for the quarter for the first time since 2014.
Don’t pop the champagne just yet as the analytical team at Capital Economics thinks that the recent inversion of parts of the yield curve is a bad sign for the S&P 500. “In the past, when the yield of the 10-year Treasury has fallen below the yield of most Treasuries with shorter maturities, the S&P 500 has fallen in the next twelve to eighteen months.”