The S&P 500 Index fell 1.3% last week and remains in a trading range with concerns centered on the Federal Reserve raising interest rates, the recent yield curve inversion, and the potential for a significant economic slowdown or recession. We think it’s important to put historical context around yield curve inversions and have the following observations on the most recent inversions.
Yield Curve Inversion Defined
A yield curve inversion occurs when short-term interest rates move higher than long-term rates. Yield curves invert close to the peak of an economic cycle, and after a peak there is inevitably a slowdown or recession. Consequently, talk of recession intensifies when the yield curve inverts. It’s important to note that an inverted curve, no matter the maturities involved, is not very good at predicting the timing of recessions. Historically, recessions follow inversions, with long and variable lags (as described below).
The yield curve between 2 and 10 years inverted recently and has raised recession concerns. The recent flattening of yields has been caused by expectations that the Federal Reserve will raise interest rates too high in its inflation fight and that this will lead to a recession. However, not all the curve has been flattening or inverting. The short end (using the 3-month to 2- or 10-year Treasury) remains relatively steep. Importantly, studies show that the 3-month to 2- or 10-year Treasury yield is statistically best at predicting recessions. This suggests to us that it is too early to make a recession call that would impact corporate profits and stock prices.
The 2019 Inversion
The Federal Reserve raised interest rates from December 2015 until December 2018. Following the last hike in December 2018, stocks were off their peak by about 20% and helped cause the Fed to reverse course on higher rates. Stocks rallied throughout 2019, but the 2- to 10-year yield curve still saw an inversion in August 2019.
However, stocks posted positive returns of 8% three months after this inversion and all the way to 18% by six months after—around the stock market peak in February 2020 right before start of pandemic. Even with the 34% pandemic induced selloff in March of 2020, stocks rebounded in the summer of 2020 to gain back the positive 18% by the one-year mark after the August 2019 inversion. Given that the coronavirus wasn’t identified until December of 2019, we don’t view the 2019 inversion as sending a useful signal for the economy or stocks.
The 2005 Inversion
The 2- to 10-year yield curve inverted in December 2005 after a Fed tightening cycle. However, the Great Recession didn’t start until December 2007, a full two years after the initial 2-10 inversion. Meanwhile, stocks were up 13% one year after the inversion and 17% after two years (the stock market peaked in October 2007 prior to the onset of the Great Recession).
The 2000 Inversion
The 2- to 10-year curve inverted in February 2000 with a recession showing up 14 months later. Stocks were down 5% one year after the inversion—stocks peaked in March 2000 after one of the greatest bull markets in history with stock valuations at an extreme.
The 1998 and 1988 Inversions
The 2-10 inverted in May 1998 with concerns centered on emerging market financial stresses. This inversion provided a false recession signal with stocks up 25% one year later and 34% two years later. The 2-10 inverted in December 1988. However, stocks were up 25% one year later and the next recession was 20 months later.
Our conclusion from this historical look-back is that a 2-10 inversion sends a poor recession and stock timing signal (at best) and can’t be looked at in isolation. There are many other economic and market factors that must be considered. With this in mind, we remain positive on the economic outlook.
Last week’s economic readings continue to suggest a healthy economy that should allow the Federal Reserve to continue hiking interest rates. The combined latest readings of the ISM Manufacturing and Services PMIs (timely business surveys) are consistent with about 4% economic growth. The Philly Fed State Coincident Indexes rose in 49 states, consistent with a sustained recovery and minimal odds of a near-term recession. Jobless claims stand at lowest level since 1968, suggesting a very healthy labor market.
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