10 Things To Know About Inverted Yield Curves

Posted by lplresearch

Wednesday, April 6, 2022

One of the biggest stories over the past few weeks has been the inversion of various points on the U.S. Treasury yield curve. The more well-known 2-year/10-year yield curve spread inverted on April 1, 2022 for the first time since 2019, while the 5-year/30-year inverted for the first time since 2006 on March 28.

What is a yield curve? The yield curve plots the yield of different maturity bonds, usually Treasuries. In normal times, a longer dated bond should have a higher yield than a shorter dated bond. Historically, after key parts of the yield curve invert, the economy eventually has moved into a recession. This is why these signals are quiet important.

Here are ten things to know about the yield curve.

  • Yes, past recessions have been proceeded by an inverted yield curve, but by no means does it happen right away. Another way to put it is yield curve inversions have preceded all recessions, but not all inverted yield curves lead to a recession. Historically, when the 2-year/10-year yield curve inverts, a recession has taken place an average about 19 months later.

View enlarged chart.

  • What about stocks? “One of the bigger surprises for investors is that stocks historically have actually done quite well after previous inversions,” explained LPL Chief Market Strategist Ryan Detrick. “In fact, the S&P 500 Index gained another 29% on average and peaked nearly 17 months later after the previous four inversions.” The bottom line is a yield curve inversion is a warning sign, but by no means does that mean trouble is coming immediately.

View enlarged chart.

  • In the LPL Research Chart of the Day (shown below), here is how the S&P 500 has done after all the 2-year/10-year inversions going back to the mid-1960s. Once again, some of the more recent performance has been quite impressive.

View enlarged chart.

  • One thing investors seem to be ignoring lately though is the short-end of the curve. In fact, the Federal Reserve Bank (Fed) came out recently saying as much in Don’t Fear the Yield CurveThey concluded that the 2-year/10-year yield curve wasn’t a good indicator for recessions; instead the near-term spread between the 3-month/18-month forward yield curve has been much better. Take note that the 3-month/18-month forward yield curve has steepened significantly the past few months, reducing the chances of a recession. Speaking of the Fed, Chairman Powell said last month that the economy was on firm footing and would be able to withstand rate hikes. In other words, the Fed isn’t worried about a recession quite yet.
  • Along these lines, the 3-month/10-year yield curve recently was at its steepest level in 5 years! This has been our personal favorite part of the yield curve to use as a signal for a pending recession (as the 2-year/10-year has given false signals before) and if and until this curve inverts, we believe the odds of a recession on the horizon is limited.

View enlarged chart.

  • Yield curves are one part of the bond market, but what the credit markets are saying is another (think of them as bond investors take on financial conditions) and we see a much different opinion here. Lately, high yield bonds have outperformed Treasuries ( Bloomberg US Corporate High Yield index and the Bloomberg US Treasury index), a clue the credit markets weren’t very worried about economic growth going forward. In the past, trouble starts brewing when high yield underperforms Treasuries.
  • Adding to this, spreads on high yield and investment grade corporates have both come back significantly the past few weeks. “To see credit markets showing major signs of improvement the past few weeks is a great sign that financial conditions are probably better than most think,” explained Detrick. “Yes, the yield curve is flashing some warnings, but overall the credit markets are saying don’t get overly worried just yet.”

View enlarged chart.

  • Real rates (rates adjusted for inflation) are negative. With the 10-year breakeven rate, what the bond market thinks inflation will average over the next 10 years, currently near 2.8% and the 10-year Treasury yield currently near 2.5%, real yields are actually negative. Historically, negative real rates have been quite bullish for risk assets. The Roaring 1920s, then during the 1940s and 1950s, were the last time we saw an extended period of negative real rates. As history told us, those decades saw explosive growth and stock market gains.
  • Real yield curves (adjusted for inflation) are still upwardly sloping. Take note, we’ve seen real yields invert ahead of recessions in the past along with nominal yield curves (2006 and 2019 most recently), yet another clue a recession might not be as close as some fear. Meanwhile, Goldman Sachs noted that nominal curves tend to invert more easily in high inflation environments (we can check this box now), suggesting it would take a deeper inversion than recent cycles to trigger a recession signal.

View enlarged chart.

  • Lastly, the Fed owns nearly $9 trillion in bonds and 25% of the entire Treasury market. Who knows where yields would be if they didn’t own any, but most agree longer-term yields would likely be much higher. So maybe various yield curves wouldn’t be inverted or even that close to inverting? This concept is mere conjecture, but it is a note we’ve seen lately that is at least worth pointing out.

There is a lot to digest here and this isn’t an easy subject, but the bottom line is the takeaway isn’t as simple as an inverted yield curve means a recession is imminent.

For more on what the yield curve could be saying and a fun look at the Final Four of things that matter to stocks, please watch the latest LPL Market Signals podcast with Jeff Buchbinder and Ryan Detrick as they break it all down.


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