Amid the Dow Jones Industrial Average dropping 2,000 points in two days (its biggest two day drop, ever) on concerns that the coronavirus is rapidly expanding outside of China and turning into a pandemic, you probably missed something that would otherwise be dominating financial headlines everywhere. That is, in mid-February, Wall Street’s favorite recession indicator — a yield curve inversion — appeared, again, for the second time in seven months.
A yield curve inversion happens when long-term interest rates fall below short-term interest rates, indicative that investor demand for long-term fixed income instruments is unusually high and expectations for near-term economic growth are unusually low.
It’s a scary sign. A yield curve inversion has successfully predicted every U.S. recession since 1930.
So, with the yield curve inverted, the coronavirus gradually turning into a global pandemic, and the bull market in its eleventh year, is it time to call it one heck of a run, and take profits off the table?
I don’t think so. Not yet, at least.
But, in order to understand why, let’s take a step back and answer some basic questions. What exactly is a yield curve inversion? Why does it predict recessions? What normally happens after an inversion? What’s different this time around?
Let’s answer all those questions, and more, in this guide to understanding a yield curve inversion and what it means for your money today.
What Is a Yield Curve Inversion?
The yield curve inverts when long-term interest rates fall below short-term ones.
That is an abnormal circumstance in financial markets. Normally, short-term interest rates are below long-term interest rates, indicative of the fact that investors require more return for keeping their money tied up for longer.
But, when investors expect that a slowdown is coming, they don’t care about getting more return for keeping their money tied up. They just want to lock in yield. So, they pile into instruments with the best yields, which are long-term fixed income instruments. That flight into safe-haven assets pushes long-term bond prices up.
When prices go up, yields go down, and this causes a yield curve inversion.
Why Does It Predict Recessions?
A yield curve inversion is considered a reliable recession indicator on Wall Street for two reasons.
First, it’s the bond market telling you something. Many people forget this, but the bond market is actually bigger than the stock market. The global capitalization of the stock market is about $85 trillion. The global bond market measures in around $100 trillion. When $100 trillion is trying to tell you something, you should listen.
A yield curve inversion is that $100 trillion market telling you that a slowdown is coming, and that it’s time to lock in yield wherever you can find it.
Second, the yield curve has a history of getting it right. Since 1930, a yield curve inversion has successfully predicted every U.S. recession. The timing hasn’t always been perfect (more on that later). But, it has never failed to predict a major slowdown.
What Usually Happens After an Inversion?
While yield curve inversions do tend to predict recessions, they are also notoriously premature.
Specifically, a full yield curve inversion — typically defined by the 10-Year Treasury yield falling below the 2-Year Treasury yield — has only happened a handful of times over the past 50 years. Yes, each inversion successfully predicted a recession. But, on average, the stock market didn’t peak until about 20 months after the inversion happened. During those 20 months, stocks tended to post outstanding returns, with average returns north of 25%.
So, yield curves do predict recessions, but they tend to be about 20 months early, and history says you don’t want to sit out those 20 months.
Also of note, the big thing to watch is the 2-Year Treasury yield. Immediately prior to each stock market peak in the past thirty years, the yield curve actually normalized into the peak, driven by a plunge in the 2-Year Treasury yield on bond market expectations that rates were going to get cut multiple times to help thwart a forthcoming slowdown.
What’s Going to Happen Now?
The yield curve inversion is something to note. But, it’s nothing to freak out about. Yet.
We are only seven months from the 10-2 yield curve inversion in August 2019, and in the middle of the February inversion. That doesn’t line up with how these things work historically. You don’t get market peaks when everyone is freaking out about a yield curve inversion. You get market peaks when everyone forgets about the yield curve inversion, and animal spirits take over. Normally, it takes about 20 months for that to happen. That timing pegs the next market peak in the second quarter of 2021.
At the same time, the 2-Year yield is falling, but not plunging like it has before prior recessions. Until that plunges on expectations for huge rate cuts, there really isn’t much cause for concern here.
In other words, the yield curve is flashing warning signs right now — but no stop signs.
Fundamentally, I agree with the yield curve. The economy and the market have some warning signs, such as the coronavirus outbreak and slowing global growth. But, the core fundamentals remain pretty solid. Labor markets are healthy. Spending conditions are favorable. Businesses are growing. Central banks are injecting liquidity.
The fundamentals are still pretty good. So long as that remains true, this bull market likely won’t die.
Yield curve inversions are scary. The February inversion is no different. It’s scary.
But, it’s warning sign, not a stop sign. Be cognizant of the building risks in financial and equity markets. But don’t ditch stocks. This bull market isn’t over yet.
Luke Lango is a Markets Analyst for InvestorPlace. He has been professionally analyzing stocks for several years, previously working at various hedge funds and currently running his own investment fund in San Diego. A Caltech graduate, Luke has consistently been rated one of the world’s top stock pickers by TipRanks, and has developed a reputation for leveraging his technology background to identify growth stocks that deliver outstanding returns. Luke is also the founder of Fantastic, a social discovery company backed by an LA-based internet venture firm. As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.