The current bull market has been going strong since 2009. For years, some investors have been reducing equity exposure in anticipation of the next recession and bear market. Thus far, they have not been rewarded, as the S&P 500 continues to make new highs year after year.
The latest argument for reducing equity exposure by bearish investors is that the yield curve is flattening. They argue that the yield curve has been inverted prior to every recession over at least the last 40 years. Therefore, we should brace for a recession and a bear market in the near future.
It seems like everyone is talking about the yield curve, from media outlets such as the Wall Street Journal and Bloomberg, to investment banks such as Morgan Stanley and Goldman Sachs, to personal finance bloggers such as Financial Samurai and A Wealth Of Common Sense. Even the Federal Reserve has put out research reports on the inverted yield curve.
The investment thesis is so simple that it is no surprise it has become embedded into the individual investor’s psyche. In this post, let’s cut through the fear-mongering and see how a potential inverted yield curve should affect your investment plan.
What’s A Yield Curve?
First, let’s go over some basics about the Treasury bond yield curve.
The U.S. Treasury borrows money from investors, making small periodic interest payments and then paying the balance in full at some predefined time in the future (maturity date). From the expected payments, you can calculate the yield of the bond.
The U.S. Government has created Treasury bonds for a wide range of maturity dates, from very short-term maturities (one month or less) to very long-term maturities (30 years).
You can create a graph of the yield curve using Treasury bonds of different maturities, with the yield on the y-axis and maturity on the x-axis. A typical yield curve, such as this one from January 2015, might look like this:
As you can see, the shortest-term Treasury bonds have the lowest yield, while the longest-term Treasury bonds have the highest yield.
Here’s an example of an inverted Treasury yield curve from February 2007, where shorter-term Treasury bonds pay higher yields than longer-term Treasury bonds.
One measure that is tracked by investors and financial journalists is the difference (spread) between the 2-year Treasury bond and the 10-year Treasury bond. The Federal Reserve has kept track of the spread between the 2-year and 10-year Treasury bonds since 1975, and they have nicely graphed it on their website.
In this graph, the gray areas are the times when the United States has been in recession. Do you see a pattern here?
Whenever the two-year Treasury bond pays more than the 10-year Treasury bond, the economy goes into recession shortly thereafter. In the past 40 years, the U.S. economy has never gone into recession without the bond market first predicting it with an inverted yield curve. Therefore, many market observers closely follow the yield curve, believing that once the yield curve inverts, a recession will soon follow.
At the time of publication of this blog post in July 2018, the difference between the 2-year and 10-year yield was down to 0.28%. When you look at the graph of the 2y-10y spread from the Federal Reserve, you can see the steady downward trend. If the trend continues, it’s possible that the yield curve could be inverted by the end of 2018 or early 2019.
Why I’m not worried about a possible inverted yield curve
Some economists think this time is different
Some economists have given reasons why an inverted yield curve may not precede a recession in the current economic environment.
The economy is very strong, with low unemployment and inflation. Some economists believe the flattening of the yield is due to technical (supply and demand) reasons rather than economic reasons. For example, many foreign buyers are buying long-term Treasury bonds because of the very low yields in other global bond markets.
Of course, the phrase “this time is different” has burned investors for as long as there have been financial markets. This is not the main reason why I am not concerned about an inverted yield curve.
The time between the start of the inverted yield curve and the start of the recession is highly variable
Even when the yield curve nears inversion, the exact timing of the subsequent recession is variable and cannot be easily predicted.
Most of the time, the recession begins approximately 18-24 months after the yield curve inverts. However, there have been some “fake-outs”, especially if you try to predict the recession before the yield curve actually inverts.
For example, as of July 2018, the 2y-10y spread is 0.30%. The spread dropped to as low as 0.14% in 1994, with a strong trend down. If you had sold your stocks and predicted a recession at that time, you would have missed out on the big stock market gains of the late 1990s. The yield curve even inverted briefly in June 1998, nearly 3 years before the official start of the 2001-2002 recession.
The Federal Reserve watches the bond market and will act accordingly
The Federal Reserve, with its power to set short-term interest rates, has tremendous power on the Treasury yield curve. They are noticing what is happening in the Treasury market. They’ve even published research articles on the topic. In fact, the Wall Street Journal reports that they may slow down their pace of interest rate increases if they think the yield curve will invert.
The Federal Reserve may not be able to stop the recession, but they have the power through monetary policy to slow it down. Any inversion of the Treasury yield curve is typically short-lived as the Federal Reserve aggressively cuts interest rates during a recession. Remember that short-term interest rates were essentially zero for many years during and following the Great Recession.
If you knew there was a recession coming in 2 years, what would you do about it?
Let’s say an inverted yield curve is a perfect predictor of recessions and the yield curve inverts in early 2019, predicting a recession in 2020-2021. How would this affect your personal finances or investing?
Would you sell your stocks?
I wouldn’t advise this, for several reasons. The stock market keeps track of everything, including the yield curve. The market prices in the risk of recession at all times, and will begin to fall well before the recession actually happens. The inverted yield curve is just one of many economic indicators that could predict a recession.
Many investors underestimate the wisdom of the stock market and believe that publicly available, widely-monitored indicators such as the Treasury yield curve could actually be a way to beat the stock market.
In addition, if you were to reduce equity exposure in anticipation of a recession, when would you reverse the trade and increase exposure to the stock market? The obvious answer would be to wait until the recession is over before buying. While this trade always looks good on paper, timing the market is far more difficult in real life than on paper.
Would you save more or prepare for a possible job loss?
Maybe because of the inverted yield curve, you should prepare financially for a recession, either by working harder at your job or by saving more money. Certainly, if you haven’t been doing those things, it’s not too late to start now in preparation for a recession. But you should always be prepared for a recession or bear market, not just when the yield curve is inverted. Don’t be like that kid who is unprepared and tries to tidy up his room right before his mom is about to come check in on him.
Summary
- An inverted yield curve has predicted each economic recession of at least the last 40 years.
- As of this post’s publication in July 2018, the difference between the 10-year and 2-year Treasury yield is about 0.28% and falling.
- This time could be different, but even if it isn’t, the exact date of recession cannot be predicted.
- The stock market (and the Federal Reserve) are aware of the flattening yield curve, as well as the many other potential economic headwinds (e.g. new trade tariffs).
- The Federal Reserve may intervene in the event of an inverted yield curve to prevent a recession.
- The stock market has already priced in all of these economic risks, so I do not believe you can make money using this publicly available economic information.
- You should always be prepared for a recession or a bear market, not only when certain economic indicators predict them.
What do you think? Are you worried about the inverted yield curve? When do you think the next recession will occur?
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I first came across this concept from Sam of Financial Samurai. Definitely concerning when people in the know are all concluding the same thing about the yield curve. After reviewing everything it does make sense and the end of the bull market may be near. Still would not change my investing philosophy but hopefully get to buy stocks on sale as I’m still a ways out from retirement and this could be a last buying opportunity (and if not, it doesn’t matter as I keep plugging away).
Sam’s post prompted me to write my article.
Your recommendations on what actions we should take now make good sense. If not already doing it, we can begin by working harder and saving more. As Jack Bogle always says “Stay the course”
Agreed. The whole idea of index investing and staying the course is to not have to worry about reading the economic tea leaves.
Allow me to throw out my same response to Sam. Yield curve inversion has been tied to US recessions in the past. But it hasn’t been tied as such in other countries. In fact in places like Australia inversions have happened a few times during their current bull market. Same in Japan and much of Europe. What this means is quite clearly correlation is not 100 percent, our small US sample size is not sufficient to say anything.
Yea, I definitely saw the research that indicated that the inverted yield curve did not always predict recession in non-US countries.
Another point, which you alluded to, but don’t explicitly state, is the fact that recessions and bear markets are not the same thing. An economic slowdown is generally not good for stocks, but the two don’t march in lockstep. As you point out, the likelihood of a future downturn is generally priced in.
Staying the course,
-PoF
Agreed — if the yield curve indicator is meaningful, the stock market would decline as the yield curve flattened. The stock market does not seem to be heeding the yield curve much attention, even though pretty much everyone in the market is aware of it.
Great piece, WSP, I appreciate your simplified explanation ( had read Sam’s post as well).
A part of me often wants to quote Benjamin Graham, who likened analysts with their charts of past decades of stock performance and perfectly dredged data to the modern major general from The Pirates Of Penzance, “with many cheerful facts about the square of the hypotenuse.”
It’s fascinating to develop a deeper understanding of the flashing red lights and indicators tracked by financial professionals (“But some of my best friends are investment bankers!” he awkwardly protested).
Still, as it doesn’t alter the management of my personal finances, it’s more for personal edification than as a basis for future investing behavior. There’s a beauty in remaining oblivious, as Mike Piper alluded to in the name of his popular blog.
Appreciate the education,
CD
If it doesn’t change your management, you don’t need to check it. True with ordering medical tests as well as tracking the yield curve.
Great article and explanation! The problem with using the yield curve today is that rates are so low, the absolute gap between the 2-year and 10-year is going to be shrinking versus historical levels automatically (as you can see in the chart has been happening really since 2014).
However, even with rates up slightly over the last year, the gap is still shrinking. But interestingly most bond investors aren’t overly worried. The demand for debt investment – loans, investment grade, and junk bonds – has been increasing significantly. Especially as the real rate in Europe is still negative so a lot of foreign money is looking to invest in U.S. gov’t and corporate debt.
“This time is different” is certainly a risky phrase. And a bear market or recession will come. But it is at least worth noting that rates are incredibly low compared to historical levels and the debt investment markets are more mature and in higher demand than ever before.
Thanks for the tip about the low absolute yield argument for why this time is different — I considered including it in the article, but cut it in the final draft.
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