Historic Market News: 12/11/2018Submitted by Executive Wealth Management on December 14th, 2018
Last week, we saw a slight inversion in the yield curve for U.S. Treasuries. This was promoted by many in the financial media as an “ominous signal” for the U.S. economy and stock market. Let’s take a moment to look at why this is so.
Normally, in a growing economy, the longer the maturity of a U.S. government bond, the greater the perceived risk. The possibility of increasing interest rates and inflation as economic growth continues means that investors expect to be compensated with higher yields when their money is locked up for longer periods of time. This implies that a plot of yield versus maturity for U.S. Treasuries, known as the yield curve, will slope upwards. However, if there is a growing concern that interest rates could fall in the foreseeable future, possibly as economic growth sputters or declines, then investors could rush to lock in the comparatively high yield of longer-term bonds. This increased demand will push the price of these bonds up and their yield down relative to shorter-term bonds. This results in an inverted yield curve. Traditionally, analysts have watched for an inversion in the yields for the 2-year and 10-year Treasuries, or three-month and 10-year Treasuries and noticed that they have been useful, but not perfect, predictors of future economic recessions and bear markets. Last week, however, it was the 5-year Treasury yield that dipped below the 3-year and 2-year yields (a 0.02% inversion by Friday’s market close— a graph of that day’s yield curve and a comparison of its movement over the last month is indicated in the graph below).
According to research from Richard Bernstein Advisors, since 1965, the 3-year yield has been higher than the 5-year yield on seven previous occasions. In 1973, the U.S. economy was already in a recession when the inversion happened. In the other six instances, the median distance between the inversion and an economic recession was 25 months. Also in these six cases, the median return for the S&P 500 over the next two years following the inversion was 20%.
It is important to remember that the U.S. Treasury yield curve is ultimately a sentiment indicator of fixed income investors, not an infallible measurement of economic activity. Even if historically it has pointed to a future downturn in the economy and stock market, the data above indicates that by itself it isn’t a signal to adjust portfolio allocations.