What to Make of the Yield Curve
I’ve often mentioned yield curve inversions are like earthquake warning signals. Some SEISMIC activity or small tremors often warn you of bigger tremors ahead. But the problem is, you just don’t know when. It could be 1, 5, 10 or even 50 years before the “BIG ONE” or big earthquake strikes. Meanwhile, what do you do? Uproot your family, sell your home, change jobs and relocate to another city with less earthquake risk?
Below are two tables for your reference. Why you should not panic after an inversion:
1. A persistent inversion of one to two quarters of the 2 and 10 years yield is necessary for the inversion to count, not for a few minutes.
2. Look at “Figure 6”. The lag period of inversion to recession ranged from as short as 14 months in 2001, to as long as 34 months in 2001! You could wait nearly 3 years to see a recession. The average time lag to a recession is 22 months. That’s 1 year 10 months.
3. The lag period from inversion to stock market peak is unpredictable as well. In the 1978 inversion, stock markets were still rallying 36 months after. In 2000, stock markets rose for another 6 months only. On average, the S&P500 rises 15.7% 18 months after the inversion.
Conclusion
From my observation, the yield curve inversion is no doubt accurate, but the timing of the recession is uncertain. We could see a recession in as early as Oct 2020, or as late as 2022 June. At best, I will use it to start preparing my business, real estate, or any illiquid assets for a down turn in a year’s time.
But for stocks, or other liquid investments, things that I can get out easily, it may be too early to unwind now. If the lag is 36 months before market peaks, in the case of the 1978 inversion, you could miss out on 27% returns from stocks.
Many investors do the wrong thing. When they see an inversion, they liquidate the most liquid investments, but continue with their illiquid investments, continue to buy real estate at very poor yields. Ideally, they should do the opposite. Buy illiquid investments only if they fulfill very stringent criteria like net yield over mortgage cost spread of 3.5% and above. Because you need to last through a winter. Otherwise they should keep cash, hold liquid stocks, bonds, hedge funds, gold and silver.
Yield Curve Inversions & Recessions
Yield Curve Inverts
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Recession Begins
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Lag Time
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Aug 1978
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Jan 1980
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17 Months
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Sept 1980
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July 1981
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10 Months
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Dec 1988
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July 1990
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19 Months
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Feb 2000
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March 2001
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13 Months
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Dec 2005
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Oct 2007
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22 Months
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This Recession Indicator Is Going Off—but Here’s Why You Shouldn’t Use It to Time the Market
By
August 13, 2019
One of the biggest surprises to market participants this year has been the big move lower in interest rates. When the Wall Street Journal polled 69 economists in January, not a single one predicted 10 year treasury rates would fall below 2.5% by June (the actual rate was closer to 2% by then). The average forecast from this group of experts was 3%. The 10 year is currently yielding close to 1.7%.
The 10 year is the benchmark most people look at when gauging the interest rate environment but when yields move they never do so in a parallel manner across the different maturities. So even as the 10 year has dropped like a rock in 2019, other parts of the yield curve haven't moved as much, most notably, rates that are shorter in duration. Here is a look at how various maturities in U.S. treasuries have changed from the start of 2019:
You'll notice 3 month t-bills yields now exceed the 10 year and 2 year rates while the 30 year is fast approaching the 2% threshold. In a "normal" environment we would expect longer-term rates to be higher than short-term rates for the simple fact that investors must accept more duration risk, or volatility, in their bonds by going further out on the maturity spectrum.
The difference between long-term rates and short-term rates is called the yield curve. In a healthy economic environment, it should be upward sloping. When bond investors become worried about the economy slowing, it tends to invert, where short-term bonds yield more than long-term bonds. Going back to the late-1970s, an inverted yield curve has been a reliable indicator of a coming recession:
This signal hasn't worked on a set schedule but every time the 10 year treasury has yielded less than the 2 year treasury, a recession has shown up eventually. The average lag time is roughly 17 months from the time the yield curve inverts until the onset of a recession, but the timing of the results can vary.
Recessionary periods typically aren't great for the stock market so as we enter an environment where short-term bonds yield more than long-term bonds, investors are wondering what this means for their stocks.
Eugene Fama and Ken French recently published a research paper on the topic called Inverted Yield Curve and Expected Stock Returns. Fama and French took their dataset back to 1975, across 11 major stock and bond markets to determine if an inverted yield curve could predict the stock market underperforming short-term treasury bills (a proxy for cash). They compared six different yield spreads, switching from stocks to t-bills when any of these yield curves inverted. Then they looked out over the next one, two, three, and five year periods to see what happened when switching from stocks to cash.
The duo's conclusion states that, "We find no evidence that inverted yield curves predict stocks will underperform Treasury bills for forecast periods of one, two, three, and five years." They compared three broad market indexes, using the U.S. stock market, the World stock market, and the World ex-U.S. stock market. The switching strategy of going from stocks to cash underperformed a long-only buy and hold strategy in all 24 instances using the U.S. and World markets. The yield curve signal also underperformed in 19 of 24 World ex-U.S. backtests.
No one knows if the yield curve will work as a reliable economic indicator going forward. It's possible the simple fact that investors are now aware of this signal could alter its usefulness going forward.
But even if an inverted yield curve does prove itself as a reliable recessionary indicator, the data doesn't necessarily allow you to take advantage in the stock market on a consistent basis. The stock market and the economy rarely move in lock-step with one another. So while an inverted yield curve could mean we see a recession sometime in the next couple of years, that doesn't make it any easier to time the stock market.
Ben Carlson, CFA is the Director of Institutional Asset Management at Ritholtz Wealth Management.
https://www.cnbc.com/2019/08/13/after-yield-curve-inverts-stocks-typically-have-18-months-before-doom.html
After a key yield curve inversion, stocks typically have another year and a half before doom strikes
Published Wed, Aug 14 2019 7:15 AM EDTUpdated Wed, Aug 14 2019 12:44 PM EDT
Key Points
- The fearsome inversion of the key 2-year and 10-year yields finally happened early Wednesday, sending markets reeling.
- Historical analysis shows that stocks typically have another 18 months to rally after an inversion, then trouble hits.
Stocks plunged on recession fears—Six experts on what it means for markets
The inversion of the yield curve has been a big worry on traders’ minds all year, but historical analysis shows that stocks typically have another 18 months to rally before equity markets start to see signs of trouble.
Strategists first started publishing research on yield-curve data last summer, when a rise in short-term rates narrowed the spread between the 3-month bill rate and 10-year yield to levels not seen since the financial crisis. That part of the curve eventually inverted, but stocks continued to hit new highs.
But they’ve been waiting for the main event: An inversion of the key 2-year and 10-year yields. That occurred early Wednesday and sent stock futures reeling as traders bet this was the reliable recession indicator and the one to watch.
“While an inversion has preceded each recession over the past 50 years, the lead time is extremely inconsistent,” Jonathan Golub, chief U.S. equity strategist at Credit Suisse, wrote in July 2018. “Historically, an inverted yield curve has been accompanied by a variety of other ominous economic signals including layoffs and credit deterioration.”
Stocks typically have 18 months of gains following inversion of the 2-10 spread until returns start to turn negative, Credit Suisse data showed.
The market rallies more than 15% on average in the 18 months following the inversion. A recession hits in 22 months after the inversion, according to Credit Suisse. Sequential losses can start to add up after 18 months, Golub’s analysis showed. Yields fall as bond prices rise.
For example, the 2-10 curve first inverted ahead of the financial crisis on Dec. 30, 2005. The market posted a cumulative gain of 18.4% in the 18 months thereafter, but returned intensifying losses after 1½ years.
Echoing Golub’s analysis, Bank of America Merrill Lynch cautioned on Monday that the “S&P 500 [is] on borrowed time if the 2s10s yield curve inverts.”
“The BofAML US Economics team suggests that recession risks are rising. The 3-month T-Bill vs the 10-year T-Note curve has already inverted and the risk is that the 2s10s curve inverts as well,” BofA technical strategist Stephen Suttmeier wrote.
“Sometimes the S&P 500 peaks within two to three months of a 2s10s inversion but it can take one to two years for an S&P 500 peak after an inversion,” he added, noting that a 2-10 inversion has preceded the most recent seven recession as well as nine of the last 12.
The average and median length of time from inversion to the start of recession and 15.1 and 16.3 months, respectively, the Bank of America analysis showed.
“The typical pattern is the yield curve inverts, the S&P 500 tops sometime after the curve inverts [see above] and the US economy goes into recession six to seven months after the S&P 500 peaks,” he added.
“After the initial drawdown, the S&P 500 can have a meaningful last gasp rally.”
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