By Jack Forehand, CFA, CFP® (@practicalquant) —
It seems like are never a shortage of issues out there that can cause fear for investors. There is always at least some wall of worry that the market has to climb. But the current time seems to be a much bigger wall than normal. We are currently experiencing inflation higher than many of us have seen in our lifetimes, rapidly rising rates and worries about whether the Fed will be able institute a soft landing for the economy. And to top it off, we also have a major international conflict and rising geopolitical tensions on multiple fronts.
While all of us those issues are certainly significant potential problems for the market going forward, another issue has been added to the list in the last couple of weeks. For the first time since prior to the 2020 bear market, the yield curve recently inverted, with the 2-year yield rising above the 10-year yield. The situation has since reversed itself, but this indicator has a very strong record of predicting potential future recessions.
Given the recent inversion, I thought now would be a good time to take a step back and look at what the data says about inversions and what they potentially mean for investors.
The History of Inversions
Cam Harvey is largely credited with identifying yield curve inversion as a future recession indicator in his 1986 dissertation. In his paper, he found that when the 10-year yield fell below the 3-month yield, it was a very consistent predictor of future recessions. As you can see from the chart below, in recent decades it has continued to work, as each of the inversions was eventually follow by a recession (in gray). It is important to keep in mind that the key word in the previous sentence is “eventually.” But more on that in a minute.
One thing you might have noticed already is that I have contradicted myself. I said in the first section of the article that the yield curve recently inverted, but this chart shows no sign of that. The reason for that is a key point to understand when thinking about yield curve inversions – there is no one way to measure them.
Many market participants like to use the 2-year treasury yield relative to the 10-year instead. We did recently get a slight inversion there, which is what has been reported in the media. As is the case with many things in investing, the devil is in the details.
The Yield Curve Doesn’t Cause Recessions
One of the biggest misconceptions about inversions is that they cause recessions. But that isn’t the case. Just because inversions typically precede recessions doesn’t mean they have anything to do with making them happen. To understand why, it is important to understand what a yield curve is. The yield curve represents a picture of what market participants think about the future of rates and the economy. When they expect growth and higher rates, it will be steeper. When they don’t, it will be flat or even invert. An inverted yield curve doesn’t cause a recession. It conveys market expectations that there is higher potential for one in the future. And the market is very smart, so it is usually right.
Timing is Everything
For arguments sake, let’s assume the yield curve will be correct and will predict every recession from here on out. That would certainly be a valuable piece of information for us to have as investor. But it wouldn’t be nearly as useful from a practical standpoint as you think. There are two reasons for that. First, although yield curve inversion has been a good recessions predictor, it has not done a good job of predicting the timing. Look back at the first chart in the article. Some of the inversions like 2000 were quickly followed by recessions, but in other cases, the recession didn’t come for up to two years. This significantly limits the ability for an investor to make this signal actionable.
But that isn’t even the biggest issue. The biggest issue is that the stock market is not the economy. An impending recession does not tell us much about what the market will do between now and then (or even what it will do once the recession hits).
This chart from a recent Ben Carlson article makes this point very clearly.
https://awealthofcommonsense.com/2022/04/the-predictive-power-of-the-yield-curve/
All of the inversions in the chart were eventually followed by a market downturn. But in most cases the market went up significantly before the downturn occurred. Sitting in cash waiting for the recession was not a good strategy. Shorting the market was an even worse one.
The Impact of the Fed
It is also important to keep in mind that the Federal Reserve has done a massive amount of buying in recent years further out on the yield curve. I am not an expert in Federal Reserve policy, but it would certainly be reasonable to think that has driven down yields at the long end and flattened the yield curve. This could potentially make the yield curve signal less strong since it is being impacted by an external force that does not reflect the views of market participants.
Don’t Fear the Inversion
Yield curve inversions can certainly be scary for investors, especially when you consider the indicator’s strong historical success rate in predicting recessions. But as is the case with any indicator, it is important to ask not only if it works, but also whether it can be used in the real world to make changes to a portfolio to increase future expected returns. This is where yield curve inversions fall down. Although they generate a lot of media attention and can be interesting to discuss at cocktail parties, they are of little value from a practical standpoint for the average investor.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.
