Does an Inverted Yield Curve Always Precede a Recession?

Investors should note an inversion does not necessarily indicate a recession is imminent

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John Kinsellagh
Mar 28, 2019
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The yield curve inverted recently, when the gap between 10-year and three-month Treasuries narrowed and finally disappeared, ending with the three-month yield higher than the 10-year note. The gap, or premium investors demand for holding the longer-term Treasuries, had been narrowing for the past year.

An inverted yield curve has been a reliable indicator of past recessions, having inverted before each of the last seven recessionary periods according to the National Bureau of Economic Research.

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There are several factors, however, that need to be considered before a recession can be reliably predicted. In short, although an inverted yield curve may provide a tight correlation between changes in interest rates and a looming recession, anticipating exactly when a downturn will occur after the inversion is an inexact science. According to data from Bianco Research, past recessions have been preceded by inversions that lasted for 10 days straight. Should the 10-year yield rise back above the three-month Treasury bills and the inversion is broken, the predictive power of the rate flip would be diminished.

Over the past three months, yields have seesawed as mixed signals about the economy made predicting Federal Reserve policy difficult. There are other factors that ebb and flow in terms of their impact on short-term rates, such as the ever-changing status of the trade dispute with China as well as data indicating slowing global growth.

Additionally, the duration of the inversion is an important factor. Even if the inversion lasts for 10 days or longer, data indicates a recession is not necessarily imminent. Bianco Research notes the past six times there has been an inversion for over 10 days, a recession has followed not immediately, but during the following two years, or an average period of 311 days.

It is also instructive to note the investment climate for the past 10 years has been heavily skewed toward equities. The bull market has occurred in an environment of unprecedented zero-interest rates for a decade. Quantitative easing resulted in an inverse bond-equity relationship. Fixed-income yields were practically nonexistent as investors shunned bonds because of their historically low yields.

The gap, or risk premium that investors require for locking up their money for longer periods, has been negligible for the past 10 years. This means that in todays still historically low-rate environment, it doesnt take much for the yield curve to invert. Thus, even a small cut in rates will have an outsized or disproportionate impact on the likelihood for inversion.

Investors are more concerned with whether an inverted yield curve is a reliable and accurate recession predictor and, perhaps more importantly, how much advance warning it provides.

What effect does an inverted yield curve have on the market?

According to a Credit Suisse analysis released last July, the S&P 500 has increased approximately 16% in the 18 months following a yield curve inversion for those periods since 1978. Stocks also manage to appreciate over longer periods, increasing 14% on average in the 24 months following an inversion and 9.5% for the 30-month period thereafter.

Historical data suggests that an inverted yield curve does not mean a recession will follow immediately. Rather, it can occur one to two years later. Given the plethora of factors that impact the yield curve as well as mixed signals on the economy and a tergiversation in short-term yields, investors should be mindful that what matters is the duration of the inversion and what the long-term impact will be for bond yields as well as the stock market.

Given all the uncertainties, investors can be sure of one thing: a yield curve inversion, by itself, for a short period, is not a reliable predictor of a recession. Investors should also be aware of the ramifications a 10-year period of zero-interest rates might have on bucking the historical correlation.

The historically prolonged low interest rate anomaly may be a factor in determining how long the rate inversion will last and what subsequent long-term effects coming off a decade-long period of easy money will have on the connection between the inversion and the timing of a recession.

Disclosure: I have no positions in any of the securities referenced in this article.

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John Kinsellagh is a financial writer, former financial advisor and attorney, with over twenty-years experience in civil litigation and securities law. He completed the Boston Security Analysts Society course on Investment Analysis and Portfolio Management. He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community, and personal finance. He is the author of "Election 2016" and "Mainstream Media- Democratic Party-Complex," both available on Amazon.com