Yesterday, the yield on the benchmark 10-year Treasury note broke below the yield on the 2-year Treasury note. This phenomenon, known as an inversion, sparked concerns over a looming recession and led U.S. stock markets to their largest daily decline of 2019. What is a yield curve inversion and what are the implications for stocks and the economy?
What is an inverted yield curve?
The yield curve is a chart that shows the yield of various government issued debt from very short dated (i.e. 1-month, 2-month) to very long dated (i.e. 20-year, 30-year) maturities. In normal environments, investors are compensated more for lending their money to the government for longer periods of time than shorter periods of time. This means that the slope of the curve is typically upward.
In periods of expected economic stress, yields tend to fall on longer-dated maturities, leading to short-term rates being higher than long-term rates. This phenomenon is known as an inverted yield curve. This has historically been a precursor to recessions as well as bear markets in stocks.
While yields of various maturities have been inverted for months, the classic inversion has been when the 10-year yield falls below the 2-year yield. This occurred for the first time since December 2005 yesterday, though as of this writing , the 10-year yield is currently higher again (slightly) than the 2-year yield.
What are the implications?
According to Credit Suisse, the last five 2-10 inversions have eventually led to a recession (see chart below which shows recessions as the vertical gray areas). However, while the inversion has preceded a recession in these five instances, the stock market, perhaps surprisingly, has also exhibited strong performance in the period following the inversion.
As Credit Suisse notes:
- A recession occurs, on average, 22 months following a 2-10 inversion.
- The S&P 500 is up, on average, 12% one year after a 2-10 inversion.
- It’s not until about 10 months after an inversion when the stock market usually turns and posts negative returns.
Of course, history is just a guide, and while the inversion leads to the increased possibility of a recession, it is not a certainty. While an inverted yield curve has preceded every recession since World War II, there have been two occasions over this period where the yield curve inverted and a recession did not follow. So, it’s a good, but not perfect, track record.
The fact that the 2-10 yield curve inverted yesterday in and of itself leads to no immediate action on our part. Risks have been rising for months and portfolios are already positioned for a more challenging environment.
Since the January 2018 high, the S&P 500 index has risen a cumulative 2%. In that approximately 18 months, the S&P 500 has seen two five percent, a ten percent, and a twenty percent correction.
We continue to hold cash in equity strategies as opposed to being fully invested as well as utilize alternative investments which are uncorrelated to the stock market. We monitor market and economic developments on an ongoing basis and will continue to adjust portfolios as markets dictate.
As always, we’re here to respond to any questions you may have about implications specific to your financial situation.
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