If you watch the news today, it is almost certain you will learn the yield curve inverted (the 2yr/10yr spread) this morning for the first time since 2007. This will probably result in a challenging market experience today (and perhaps days ahead). You will also hear inversion – a condition where short term interest rates are higher than longer term rates – is significant because it sports a strong track record for correctly signaling that an economic recession develops at some point in the not distant future. With the curve flattening for the better part of 18 months, and some maturities first inverting earlier this year, we’ve discussed why we too believe the curve slope is relevant and worth monitoring. We do not dismiss the condition as insignificant; it signals that a policy mistake is being made and damage to the economy is building. It is evidence that monetary policy is too tight for the current economic situation as a whole and will become restrictive. The ongoing friction between the US and China over trade is part of that restrictive cocktail, and the Fed should not delay in responding further via additional rate cuts in the months ahead.
With those acknowledgements made, we believe there is additional context that is important for investors to consider:
- Curve inversion does not signal economic recession will develop immediately (or at all). But on average, inversion of the 2/10 curve leads the economy entering recession by 18-22 months; and a peak in the stock market peak roughly 5 months earlier.
- Surprisingly, S&P performance is often better than average in the 12 months following a 2/10 inversion. Computer trading is more prevalent today than at prior inversions which may cause some to say that “this time is different” (most dangerous words in investing), but historical data should not be ignored.
- Both points above imply that the stock market will go on to make new highs – even if the curve signal turns out correct and economic recession develops.
- Inversion signal should not require a magnifying glass to observe; a very slight technical inversion or small inversion that exists for only a very short span in time does not have the same significance as one that is obvious to the naked eye. This fits with the idea that the Fed should respond decisively and in quick order to better align their short-term interest rate target with the market.
- A flat curve can be maintained for a long period of time; the period running 1994-98 is an often cited example and was very fruitful period for the stock market.
- Some presently suggest that the credibility of the yield curve message is diminished when acknowledging US treasury yields are being distorted by its attractiveness relative to the some $15 trillion worth of negative yielding sovereign debt abroad (Germany, Japan, etc).
- Corporate credit spreads are still behaving OK; at the moment this suggests that not even bond markets are fully convinced this inversion signals recession is certain… yet. One would ordinarily expect corporate bond credit spreads to widen (sell-off) more noticeably if economic conditions are deteriorating and recession were becoming more imminent.
The historical context all suggests that investors would be wise to avoid what might be an impulse to time the market by “selling everything”. A single indicator, no matter how historically reliable, does not ensure that a recession is on the horizon. The environment is fluid. On the other hand, one cannot dismiss that chinks in the armor of the economy and market are building; the age of the current cycle is increasingly a liability to sentiment (market, business, etc.). It is why we continue to reduce risk within both stock and bond components of client portfolios. We know market timing is not a recipe for repeatable investment success and we must participate (albeit to a more guarded extent) in what the market may continue to offer on the upside. It’s been said (and true) that more money has been lost trying to anticipate the next downturn than would be in downturns themselves and/or then feeling good enough to jump back in. All client portfolios feature the flexibility of owning cash, bonds, and stocks. These components (buckets of time as we often refer to them) are intended to match one’s needs for money with the time horizons over which different investment asset classes historically produced positive returns.