Dark Days Ahead? Yield Curve Inversion as a Recession Predictor

For the first time since 2007, shorter-term yields on U.S. Treasury securities are higher than some of their longer-term counterparts, a phenomenon referred to as an inverted yield curve.

At the end of March, the yield on the three-month Treasury bill was higher than the benchmark 10-year note for 5 straight days. Investors often watch the difference in yields, known as the spread, between shorter- and longer-term bonds, for signs of a recession.  When economic downturns are expected, investors’ demand for long-term bonds increases, thereby sending yields lower. The reduced demand for short-term bonds increases their yield to attract investors and creates an environment where the yield curve becomes inverted.

Analyzing the yields of both the three-month Treasury bill and 10-year Treasury note going back to when data was available in 1982, we see that six of the last seven instances where the yield curve was inverted coincide with either an economic recession or served as a leading indicator for a US economic recession in the following year.

*Source: www.federalreserve.gov

Although more often than not, an inverted yield curve has either preceded or coincided with a recession, it’s important to clarify that this doesn’t necessarily mean that the performance of balanced portfolio will be negatively affected.  In order to better analyze the potential impact of yield curve inversions on the return of a balanced portfolio, we tracked the performance of a 50/50 stock to bond portfolio over a 3-year period following each inversion occurrence. As shown below, the annualized return in each 3-year period has been positive.  

*Balanced Portfolio is comprised of 50% S&P 500 Index and 50% the Bloomberg Barclays US Aggregate Bond Index. The Portfolio is rebalanced quarterly.  Indexes do not incur the fees inherent in an investable product and such fees would reduce the returns illustrated. Past performance is not an indicator of future results.  

The takeaway here is that it is difficult to predict the timing and direction of equity market moves following a yield curve inversion.  While the handful of instances of curve inversions in the U.S. may concern investors, the small number of examples makes it difficult to determine a strong connection, and evidence suggests that it is not always a precursor to a sustained decline for balanced investors.  

Supplemental Information: Yield Curve Basics

To take a step back, yield curves show how interest rates vary across bonds of similar credit qualities, but different maturities, at specific points in time.  Bond yields change as markets digest news and events around the world, which also causes yield curves to move and change shape over time. Historically, yield curves have been mostly upwardly sloping, with shorter-term rates being lower than longer-term rates.  In times of economic expansion, there is an increased demand for capital, which may lead to inflation. For long-term bond investors to retain purchasing power over time, they expect greater compensation in the form of increased interest rates. Alternatively, short-term bond investors have the flexibility to reinvest their bonds at higher rates to keep pace with inflation, but longer-term investors don’t have that flexibility and must be compensated accordingly.  That said, there have been times were the curve has been flat (short-term rates are the same as long-term rates) and inverted (short-term rates are higher than long-term rates).

Inverted yield curves have preceded the most recent U.S. recessions, although that is not always the case.  As investors expect economic conditions to worsen and central banks to lower interest rates to spur future economic growth, they are more willing to invest in longer-term bonds as they have more confidence in the economy long term.  As demand for these longer-term bonds increases, yields drop. Simultaneously, investors have less confidence in the economy in the near term deeming it more risky. The lower demand for short-term securities results in yields rising to attract investors and thereby creates an environment where the yield curve becomes inverted.

Although yield curve inversions do often coincide with either an economic recession or serve as a leading indicator for a US economic recession in the following year, they are not a strong indication of sustained declines for a balanced investor.  

Disclosures:

Balanced Portfolio Performance

The S&P 500 stock index and the BBgBarc US Aggregate bond index were selected for inclusion in this blog because they are broad market, neutral indexes that seek to represent the total US stock and US investment grade bond markets.  They are shown simply as a reference and not because Raffa Wealth Management strategies are, or are likely to become, representative of past or expected S&P 500 or BBgBarc US Aggregate bond index performance.  Raffa Wealth Management managed accounts may own assets and follow investment strategies which cause them to differ materially from the composition and performance of the S&P 500 or BBgBarc US Aggregate bond index.  The historical performance results of these indexes do not reflect the deduction of transaction and custodial charges, or the deduction of an investment management fee, the incurrence of which would have the effect of decreasing indicated historical performance results of each index and the balanced portfolio

Data Sources:

www.federalreserve.gov

Recessions as defined by the National Bureau of Economic Research