According to the Federal Reserve Bank of San Francisco economic letter:
“Every recession over this period was preceded by an inversion of the yield curve… and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession.”
And when the U.S. sneezes, the world catches a cold.
Why does an inverted yield curve signal a possible recession?
If investors are optimistic that economic growth will continue for the long term and expect interest rates to rise, many will prefer short-term bonds now (instead of long-term bonds) in hopes of securing a higher yield later. The lower demand for long-term bonds means long-term yields rise faster compared to short-term yields, widening the spread.
However, when investors start to become pessimistic about long-term growth and expect interest rates to fall in the future, many will now purchase long-term bonds to lock in yields before they fall. The higher demand for long-term bonds now leads to long-term yields slowing or falling, narrowing the spread.
When it reaches a point where long-term yields are even lower than short-term yields, we have a negative spread (an inverted yield curve) – a scenario where investors are so pessimistic about long-term growth, they prefer to secure lower yields for long-term bonds now than risk higher yields for short-term bonds.
Therefore, a narrow/negative yield curve spread may signal that long-term investor confidence in the economy may be waning, even though it may still be booming right now.
At the moment, the Fed has been raising short-term interest rates to control inflation in the growing U.S. economy. However, long-term interest rates have been slower to rise which suggests that investors are becoming less optimistic on long-term growth.
The fifth perspective – what next?
It’s also important to note that while the U.S. yield curve spread is at its lowest since 2007, it is not yet negative. Right now, the spread between the 10-year and one-year U.S. Treasury bonds is 0.5 percentage points.
And even if the yield curve inverts, it can’t predict when a recession will happen. The above study by the Federal Reserve Bank of San Francisco noted that a recession came in as little six months to as long as two years. So the music may go on playing for some time.
But whether you decide to use the yield curve as an indicator or not, it’s good to note that the S&P 500 has risen 287.7% since March 2009. As it is, the stock market is looking rather expensive right now with the S&P 500 P/E ratio at 24.57 (as at 28 June 2018), compared to its historical median of 14.69.
The U.S. has been on a tremendous nine-year economic bull run since the Global Financial Crisis. But every economic expansion is followed by a recession — we all know that.
The only question is… when?
For more investment strategies, visit the Portfolio Construction Channel.