When to Panic About the Yield Curve

A market sell-off was imminent only once after an inverted yield curve

Senior Quantitative Analyst
Dec 12, 2018 at 7:23 AM
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The yield curve is created by plotting the yields on U.S. Treasuries at various maturities. It’s getting a lot of press lately because the five-year rate has overtaken the two-year rate. It’s expected that the 10-year rate will soon surpass the two-year rate, meaning an inversion between the more popular 2-year/10-year yield spread. An inverted yield curve is a popular predictor of recessions.

Yield Curves and Stock Prices

While recessions, or economic slowdowns, are obviously bad for stocks, they are often determined after the fact. Also, they don’t line up perfectly with stock market corrections. Below, I’m looking at historical yield-curve data, especially when the 2-year/10-year spread inverts, and focusing on the reaction of stock prices rather than when it’s determined that the economy is in recession. For us, stock prices are what’s important.   

12.11 iotwchart1

 

Here’s a chart of the S&P 500 Index (SPX) and the yield spread going back to 1988. The last two major stock crashes were preceded by a negative yield spread.   

12.11 iotwchart2

I went back to 2000 and created five brackets based on the level of the yield spread at the end of each week. I made it so each bracket had about the same number of returns. The one-year stock returns look better at high spreads. The current spread is around 13 basis points, putting us squarely in that first bracket where the S&P 500 averages about a 2% loss over the next year, with less than half of the returns positive.   

12.11 iotwchart3

Increasing vs. Decreasing Spreads

Before selling equities, however, look at the next set of tables. There’s a big difference in stock returns going forward depending on whether the spread is increasing or decreasing. As you see in the chart above, the spread is in free-fall. The returns going forward in this situation are not so black and white.

The best average return occurs in that second bracket, where there’s a relatively low spread. The current situation -- a low and decreasing spread -- shows underperformance, but the SPX still averages a one-year gain of about 3%, and two-thirds of the returns are positive.

The second table below shows the real trouble tends to start when the spread is low and then starts increasing. Once we reach that situation, it’s time to worry, as the historical returns are awful.   

12.11 iotwchart4

When the Curve Inverts

When/if we see the 10-year yield overtake the two-year yield, we’re sure to be inundated with articles explaining how a recession is imminent. The data below says to resist the urge to immediately sell your stocks.

Each time since 1976 (the year we began getting two-year yield data), when the yield curve inverted for the first time in at least a year, three out of five times the S&P returned at least 10% over the next year. Stocks lost value only one time. The longer-term returns do give reason for caution. The five-year returns were flat following the last inversion, and negative the two times before that. 

12.11 iotwchart5

The chart below shows the S&P 500 performance after each inversion occurrence listed above. The stock market sell-off was imminent in just one instance (the 2000 signal). The other four times, if you had sold out of stocks right away, you would have missed out on some decent gains over the next two years.

The five-year returns warrant some caution. In the first two instances, the returns were adequate, a little more than 10% per year annualized. The last three inversions have led to flat five-year returns or double-digit percentage losses. The average five-year return is about 20%, which is a meager 3.8% per year annualized.     

12.11 iotwchart6

Based on all this, don’t let doom-and-gloom recession articles persuade you to sell out of stocks when the yield curve first inverts. Be cautious, though, over a longer time horizon. The best course of action might be to watch the yield spread and sell once it bottoms and starts moving higher. 

 

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