The Yield Curve Is Still Inverted. Is a Recession Imminent?
In the past year, a lot has been written about U.S. interest rates and 1) whether or not the yield curve is inverted and 2) whether or not that matters.
The purpose of this article is to look at the yield curve today and share what I think it means for the US economy and markets.
First let’s cover the basics.
What is a yield curve?
The yield curve is just a graph that shows maturity on x axis and yield on the y-axis. Below I’ve shown the January 2014 yield curve for US Treasury bonds.
Figure 1: Typical Yield Curve
Source: U.S. Treasury
As you can see, the yield curve slopes up and to the right. And this makes sense. Because you are taking a risk by buying a long term bond instead of a short term one:
- If interest rates were to rise, the bonds issued at that time would be more attractive than the ones issued today. Thus, the bonds issued today would decline in price due to lower demand.
- Inflation could increase, reducing your real return. Inflation has a bigger impact on longer duration bonds.
The relationship of investors demanding a higher interest rate for longer duration bonds is referred to as the term premium.
Now look at the current yield curve.
Figure 2: Inverted Yield Curve
Source: U.S. Treasury
This is what’s called an inverted yield curve. Because many longer duration Treasury bonds (3 year, 5 year, 7 year, and 10 year) are yielding less than the shorter duration Treasury bonds (1 Month and 3 Month).
Why It Matters
Historically, an inverted yield curve has foreshadowed a recession.
The spread between the 10 year Treasury and the 2 year is most often cited in the financial press. However, it turns out that the spread between the 10 year Treasury and the 3 month is the one to watch. This spread is the best predictor of a recession according to recent research by the San Francisco Fed.
The 10-year-3-month Treasury spread went negative in March 2019 and remains negative today.
As shown in the chart below, this spread has gone negative prior to each of the last seven recessions.
Figure 3: Historical Spread Between the 10 Year and 3 Month Treasury (Recessions in Gray)
Does An Inverted Yield Curve Cause the Recession?
It is unclear if an inverted yield curve causes a recession or if the two are just correlated.
One argument for correlation (not causation) is the following.The federal reserve typically responds to economic weakness by cutting rates. Investors anticipate the cuts in short term rates. They sell short term Treasury bills and other notes, and they buy longer dated higher yielding notes. However, by doing so they drive their prices up and their yields down.
On the other hand, some argue that because banks borrow short term and lend long term, an inverted yield curve decreases banks’ net interest margin. As a result, banks pull back on lending which negatively impacts the economy. This is an argument for causation.
Perhaps it’s a mix of the two.
Is a Recession on the Horizon?
The odds suggest the U.S. will enter a recession some time relatively soon.
Let’s review the data.
(Going forward, when I refer to the “yield curve” inverting, I’m referring to the 10-year-3-month Treasury spread.)
For the past 7 instances of the yield curve (10-year-3-month spread) inverting, a recession has followed on average 12 months later. On a median basis, the recession has followed 6.5 months later. As a reminder, the yield curve inverted for the first time since the Great Financial Crisis in March 2019.
On average, from the time the yield curve inverted to the next stock market peak (before the recession), the S&P 500 has rallied by 11.9% (not including dividends).
On March 22, 2019, when the yield curve inverted, the S&P 500 closed at 2801. Since then it has rallied by 7.6% to 3,014. Based on the historical data, the S&P 500 is close to peaking (~5% potential upside remaining).
It is important to note that the above is just average data.
For the Great Financial Crisis, the yield curve first inverted on January 17, 2006. The S&P 500 peaked 21 months later in October 2007, up 22%!
In 1965, the yield curve first inverted on November 11, 1965. The S&P 500 peaked 36 months later in November 1968, up 18%!
In 1972 and 2000, the S&P 500 had already peaked by the time the yield curve inverted.
See a summary of the data below.
Figure 4: Yield Curve Inversion and S&P 500 Return To Peak
If we do enter a recession soon, what kind of downside could the S&P 500 see?
Historically, the S&P 500 has fallen by 33.2% on average from its peak.
Figure 5: Recession and Historical S&P 500 Returns – Peak to Trough
Is it Different This Time?
Fed Chairman Powell noted last year that an inverted yield curve has preceded recessions in part because “inflation was allowed to get out of control, and the Fed had to tighten, and that put the economy into recession”. Mr. Powell said, “It’s really not the situation we’re in now.”
Last year, Goldman Sachs strategists wrote to clients, “The historical correlation between yield curve inversion and recession is impressive. But it can be misleading. A consistent mapping from the slope of the yield curve to the probability of recession — is not plausible.” The reason why an inverted yield curve is not predictive of a recession? Because central bank debt purchases have shrunk the term premium – compensation investors usually demand for holding longer duration bonds.
As Bloomberg reports, even former Fed Chair, Janet Yellen, believes this is a plausible explanation:
“Some, including former Fed Chair Janet Yellen, have suggested that depressed term premium — the bonus investors require to take on the added risk of holding longer-dated bonds — could mean the curve’s flattening doesn’t herald a downturn this time around. The logic is that if long-term rates are lower thanks to government bond-buying programs and other structural factors, the curve could invert with just mildly restrictive monetary policy. In the past, it took very restrictive Fed policy to push short rates above the long end of the curve. Against today’s changed backdrop, an inversion could be a less potent predictor of recession.”
Finally, a recent Wall Street Journal article notes, “Analysts also note that cracks in the economy that have traditionally accompanied an inverted yield curve haven’t yet surfaced.”
All the arguments above suggest that maybe the inverted yield curve does not portend an imminent recession. And they all seem reasonable, but I tend to agree with Sir John Templeton that the most expensive words in the English language are “this time is different.”
Last time the yield curve inverted, many intelligent people offered very reasonable explanations as to why “this time is different.”
In January 2006, Wharton professor, Marshall Blume, when asked about the inverted yield curve, said:
“I think it sometimes portends a recession, sometimes not. All the forecasts are quite favorable. There aren’t any real excesses in the economy at the current time, and you usually think of recession as a tonic to the economy, to undo excess.”
Also in January 2006, the WSJ wrote:
“Will this latest yield-curve inversion lead to a recession? History says yes. But there are good reasons to think history won’t repeat itself now.
First, long-term rates may be unusually low for reasons unrelated to U.S. economic prospects, such as foreign buying of U.S. bonds. For example, saving is unusually high in many foreign countries and they are investing some of it in U.S. Treasury debt.
Second, short-term rates simply aren’t very high yet. The true cost of borrowing is the interest rate minus the underlying inflation rate. And with inflation at 2.1% (excluding volatile food and energy), the “real” short-term rate of about 2% is still low. It has topped 4% each time the economy went into recession since 1973.”
Despite these logical explanations as to why a recession should not have followed the yield curve inversion of 2006, we all know what followed.
What To Do Now
What should you do now?
I can’t tell you what to do, but I will tell you what I’m going to do.
#1 Invest in Defensive Investments That Are Trading at Reasonable Valuations
Economically resilient business models are particularly appealing to me right now. For instance, Insurance Auto Auctions (IAA) was just spun off from KAR Auction Services (KAR). IAA’s business is to auction off cars that have been totalled in accidents for insurance companies. Cars are wrecked in good times and bad, and IAA grew revenue through the Great Financial Crisis. However, IAA currently trades at 31x earnings and 17.0x EBITDA. It’s hard to get too excited about the stock at that valuation.
It’s difficult to find a defensive business trading at a reasonable valuation, but I will continue to look for them.
#2 If A Company Has Debt, Make Sure it Has No Imminent Maturities
Garrett Motion (GTX) (disclosure: not a recommendation) is a company with a pretty significant debt load, but it’s not something that I’m worried about. Why? It has no significant debt maturity until 2023.
If we were to enter a recession in the next year, I believe GTX would make it through without much stress.
#3 Buy When others are Indiscriminately Selling
I always focus on this, but I think it’s particularly important in the current environment when valuations are generally elevated.
Recently I was able to buy (and recommend) a spin-off a defensive company with high returns on invested capital and a reasonable debt burden at a P/E of 7.7x and a dividend yield of 7.6%.
Why was this opportunity available? Because this small cap stock was spun off from a large cap company, and the majority of shareholders could not own it due to large cap investment mandates.
The stock is already up ~13% from my average purchase price. These opportunities occur infrequently, but it’s important to take advantage of them when you see them.
Peter Lynch famously wrote, “If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.”
Nonetheless, I do think an inverted yield curve has important implications for the market and the economy.
What do you think about the inverted yield curve?
Is this time different or do you expect a recession within the next year or two?
Other Good Articles And Resources:
Barrons: Will the Flattening Yield Curve Lead to a Recession? – August 31, 2018
NYT: What’s the Yield Curve? ‘A Powerful Signal of Recessions’ Has Wall Street’s Attention – June 25, 2018
WSJ: Widely Watched Recession Signal May Be Falsely Lit by Growth – July 30, 2018
Wharton: Don’t Sweat The Yield Curve, Nobody Really Knows What it Means – January 25, 2006
Excellent 4 Minute WSJ Yield Curve Video Primer:
WSJ: Why Investors Are Obsessed With the Yield Curve