Over the past week, the market has largely brushed aside two major headwinds that have been weighing on investor sentiment. First, the market’s big concerns regarding aggressive rate hikes from the Fed were assuaged by a surprisingly dovish speech from Federal Reserve Chairman Jerome Powell. Then, the market’s trade war concerns were likewise soothed by a 90-day truce between the U.S. and China which postponed the prospect of bigger tariffs.
Yet, markets dropped in a big way on Tuesday, Dec. 4, despite a reduction of these two headwinds. Why? Because a third headwind has appeared: the flattening of the yield curve.
This fear of a flattening yield curve isn’t anything new. The yield curve has been flattening for some time now. But, it didn’t actually invert until Tuesday. On Tuesday, part of the yield curve inverted as the 5-Year Treasury yield slipped below the 2-Year Treasury yield.
Investors interpreted this as a warning shot. A yield curve inversion is considered the most robust and consistent recession indicator over the past 50 years. During that stretch, a yield curve inversion has correctly predicted every major recession.
In other words, history was screaming sell. Investors listened.
But, investors may have misheard what history was actually saying. While a flattening yield curve is a robust recession indicator, you need the whole curve to invert in order to predict a recession. Right now, only part of the curve is inverted, while the all important and most watched spread between the 10-Year Treasury yield and 3-Month Treasury yield is still at 50 basis points. Moreover, even though a 10-Year, 3 Month inversion does always correctly predict a recession, it doesn’t always get the timing right, and the market historically tends to perform strongly for several months following such an inversion.
As such, part of the yield curve inverting on Tuesday wasn’t history screaming sell now. Instead, it was history saying this market is on its last legs, but still has a few strong innings left.
Data Says It Isn’t Time to Freak Out Yet
Looking at data from the past thirty years, which we can roughly define as the era of the digital economy, we can see that we’ve had three major yield curve inversions: 1988-90, 1998-2000 and 2005-2007. All three of them started with a 5-2yr inversion, eventually fell victim to a 10yr-3mo inversion, and ultimately ended with a sizable market correction.
That’s the bad news.
But, on the positive side, such inversions take a while to play out, and as they do play out, investors tend to shrug off near-term concerns and the market tends to undergo a boom. Just look at this data from the past three major yield curve inversions:
- Average time between 5-2yr inversion and 10yr-3mo inversion: nearly 3 months
- Average time between 10yr-3mo inversion and market peak: over 18 months
- Average S&P 500 gain between 10yr-3mo inversion and market peak: over 25%
The implication is clear. While a 5-2yr inversion always predicts a 10yr-3mo inversion, and 10yr-3mo inversion always predicts an eventual market top, such inversions also always mistime the arrival of the bear market. Indeed, what tends to happen is that after a yield curve inverts, you get some weakness, but the fundamentals don’t fall apart. Investors start to say this time is different. You get a sense of euphoria in the market, and markets go through a boom phase, which eventually ends in a big bust.
We aren’t there yet.
Only part of the curve has inverted. History says we are still a few months away from the all important 10yr-3mo spread going negative. When that spread goes negative, you’ll get some choppiness in the markets. But, history says you won’t get the big correction until you get a big and unwarranted boom after that inversion.
All in all, history isn’t saying sell stocks now. Instead, part of the yield curve inverting is a warning sign, but also a sign that a market top is still several months away, and that during that stretch, we may get a big rally.
Bottom Line on the Yield Curve
No one can understate the predictive power of the yield curve inverting, nor should any investor ignore it. If the 10-Year Treasury Yield slips below the 3-Month Treasury yield, then the market is almost assuredly due for a big correction at some point in the foreseeable future.
But, that doesn’t mean it’s time to sell stocks now. Only part of the curve has inverted, while the more meaningful part remains normal with a fairly large 50 basis point spread. Also, after such inversions in the past, the market doesn’t top until after a big surge following the inversion.
We don’t have either of those things right now. The meaningful part of the yield curve hasn’t inverted, and we haven’t had that big rally when the curve is inverted. Until we get those two things, I don’t think the yield curve is telling you anything besides be careful.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.