4 Times There Was an Inverted Yield Curve (And What Happened to Stocks)

Inverted yield curves do tend to predict recessions, but such inversions are notoriously premature

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It finally happened. The market’s favorite recession indicator — an inverted yield curve as defined by 10-year Treasury rates falling below two-year Treasury rates — has finally materialized amid escalating trade tensions, slowing global growth, weak corporate earnings and uncertainty with regards to the Federal Reserve’s next move. Investors have consequently turned “end of the world” bearish, and stocks are plummeting.

As of this writing, the S&P 500, Dow Jones and Nasdaq are all roughly 5-6% off their late July 2019 highs.

Is this really the beginning of the end? Or is the inverted yield curve obsession a bit overstated? I think it’s the latter.

While it is true that a full yield curve inversion has preceded essentially every U.S. recession since 1950, it’s also true that such inversions are notoriously early. That is, with respect to the past four major yield curve inversions dating back to the late 1980s, the average duration between the inversion and a stock market top is over 12 months, and the average gain in stocks during that stretch is well over 20%.

At the same time, it’s also true that: 1) the inverted yield curve could normalize with a few rate cuts in the back half of 2019, like it did 1998, and 2) the yield curve has been relatively flattish for the past decade, so an inversion today isn’t as meaningful as it historically has been.

Net net, all the yield curve inversion talk seems a bit overdone to me. Even if the yield curve today does have as much economic predictive power as it used to, which it arguably does not, then this is a warning sign that stocks will top out in a year or more … not today.

With all that in mind, let’s take a look at the market’s four most recent major yield curve inversions, and how those inversions impacted the stock market.

The 2005-06 Inverted Yield Curve

Time From Yield Curve Inversion to Stock Market Top: 16 to 22 months

Percent Return In Stocks During That Time: Over 20%

The last time the yield curve inverted was back in 2005-06, a few years before the 2007-08 market crash and economic recession.

Specifically, there were a series of four yield curve inversions that started in December 2005, and ended in June 2006, when the spread between 10-year and two-year Treasury rates fell below zero and stayed negative until March 2007. Thus, the first inversion here was in late December 2005, while the big inversion that lasted several quarters didn’t materialize until June 2006.

At the time of both the December 2005 and June 2006 inversions, the S&P 500 was trading around 1,250. The market didn’t top out until October 2007 — 16 months after the big inversion and 22 months after the first inversion — and it topped out above 1,500, more than 20% above the levels the index was trading at when the yield curve inverted.

Thus, while the inverted yield curve was ultimately correct in predicting a recession back in the mid-2000’s, it was way too early, and preceded what ended up being a record rally in stocks before the crash.

The 2000 Inverted Yield Curve

Time From Yield Curve Inversion to Stock Market Top: Just under two months

Percent Return In Stocks During That Time: Over 10%

Prior to 2005-06, the last time the yield curve inverted was back in 2000, just before the peak of the Dot Com Bubble.

In early February 2000, the spread between the 10-year and two-year Treasury rates went negative, and stayed negative all the way until 2001. Thus, this was a big and long inversion. At the time, the S&P 500 was trading around 1,400. About two months after that inversion, in late March, the S&P 500 reached an all-time high around 1,550, which it would not see again for several years.

Thus, the 2000 inverted yield curve — unlike the 2005-06 yield curve inversion — was very timely (less than two months early). But, during those two months, stocks staged an impressive 10%-plus rally. Consequently, while the inverted yield curve was yet again right in calling in a market top, it also again preceded a big rally.

The 1998 Inverted Yield Curve

Time From Yield Curve Inversion to Stock Market Top: About 21 months

Percent Return In Stocks During That Time: Around 40%

While the 2000 yield curve inversion was very timely, the timeliness of that inversion should be taken with a grain of salt. About 18 months prior, the yield curve started flashing recession warning signs when the 10-year Treasury rate dropped below the two-year Treasury rate in June 1998.

The inversion was narrow and only lasted two months — spending a few days during that stretch in positive territory. Helping normalize the curve were three Fed rate cuts — 25 basis points each — in the back half of 1998. This pushed short-term yields lower, and pushed the 10-2 spread into positive territory, where it stayed until 2000.

Of note, this inversion happened about 21 months prior to the stock market peak in March 2000. During that time, stocks rallied about 40%. As such, it’s easy to say that this inversion — while not wrong — was premature in calling a recession (perhaps the Fed is the reason why).

The 1988/89 Inverted Yield Curve

Time From Yield Curve Inversion to Stock Market Top: Nearly 20 months

Percent Return In Stocks During That Time: Roughly 35%

The 1998 yield curve inversion was the first of its kind in essentially a decade. The previous yield curve inversion was all the way back in 1988/89.

During that time, the yield curve dramatically flattened in 1988. By early December 1988, the curve had inverted. It was a big and long inversion, with 10-year Treasury rates staying below two-year Treasury rates until late June 1989. But, during this whole inversion, stocks kept pushing higher. They continued to rally after the inversion ended, too.

Indeed, the S&P 500 didn’t top until mid-July 1990, nearly 20 months after the late 1988 inversion. Further, the S&P 500 topped out in July 1990 at 370 — roughly 35% above where the index was trading at during the time of the 1988 inversion.

Thus, consistent with the theme of pretty much all inverted yield curves, the 1988 one — while accurate — was premature and preceded a big rally in stocks.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2019/08/4-times-there-was-an-inverted-yield-curve-and-what-happened-to-stocks/.

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