Alarm bells rang on Wall Street on Wednesday as a key recessionary indicator – the slope between the 2-year Treasury yield and the 10-yr Treasury yield inverted for the first time since June 2007. With a flight-to-quality bid into longer duration Treasury securities, the yield on the ten-year Treasury was briefly lower than the yield on Treasury securities maturing in two years.
Changes in the slope of the yield curve are driven by market expectations about the business cycle. Stronger economic growth has the tendency to increase inflation and inflationary expectations, driving yields higher and bond prices down to compensate investors for the lower “real” yields. Conversely, when economic growth is weakening, you can see the yield curve flatten or even invert. Trade tensions and their impact on future growth led in part to a decline in longer-term Treasury yields as global investors have sought safety in long duration bonds.
Why is the shape of the yield curve important to Seeking Alpha readers? As graphed below, recent domestic economic recessions in the U.S. have been preceded by an inverted yield curve. In blue, I have graphed the difference between yields on 10-year Treasuries and 2-yr Treasuries. In red, is the span of economic recessions as dated by the National Bureau of Economic Research.
An inverting yield curve is a sign that participants in a large global market – the market for U.S. Treasuries – expect lower future rates. The Expectation Hypothesis of the yield curve states that the term structure of interest rates is determined by current and future short-term interest rates plus a risk premium. When the bond market is pricing in lower interest rates in several years, it signals the fact that the bond market expects lower future Fed Funds rates. Easier monetary policy is usually conducted to support slowing economic growth.
The real economy and the stock market are naturally linked, but as investors know, they are far from one and the same. In the post-crisis era, we have seen a subnormal economic recovery, yet robust equity returns. Conversely, last year, we saw a very strong domestic economy and negative equity returns. The market is inherently forward-looking, discounting future cash flows from equities back to the present. Gross domestic product figures measure only the present. This difference in time horizons can lead to disconnects between economic growth and stock market performance.
We know that inverted yield curves mean that domestic recessions have been looming, but what has that meant for stock returns? In this article, I wanted to discuss the performance of the stock market from the episode of the first inversion through the market peak and subsequent contractionary phase.
The ten year Treasury yield first moved below the two-year Treasury yield on December 27th, 2005. The yield slope would then oscillate between negative and positive for the next eighteen months. While the yield curve was already downward sloping, the Fed would lift rates from 4.25% 4.50% on January 31st, 2006, up to 4.75% on March 28th, up to 5% on May 10th, and peak at 5.25% on June 29th. The yield curve was inverted and the Fed still lifted rates by a full percentage point.
The S&P 500 (SPY) would not hit its cycle high until October 9th, 2007, a 26% return from levels when the 2s-10s slope had first inverted. This was roughly three weeks after the Fed began cutting rates with a 50bp cut on September 18th, 2007. Less than a year later, Lehman Brothers had failed and we were in the throes of the Great Recession. Stocks would not bottom until March of 2009, and not regain their October 2007 peak until early 2013.
The top of the market would come more swiftly in 2000. The yield curve inverted on February 2nd, 2000, the same day the Fed raised rates from 5.50% to 5.75%. The Fed raised rates another 25bp on March 21st. By March 24th, the S&P 500 had hit its cycle peak. The Fed raised rates by another 50bp to 6.5% on May 16th. Stocks would not bottom until October 2002. The S&P 500 would not recover its 2000 high until just before stocks topped again in 2007.
The yield curve did briefly invert the summer of 1998 as the Russian debt crisis and the blowup of hedge fund Long-Term Capital Management weighed on markets. The Fed lowered rates three times that fall, and the economic expansion successfully extended for a few more years.
The yield curve inverted, beginning on December 13th, 1988. The Fed had lowered rates by 75bp to 6.75% in the wake of Black Monday, the stock market crash that saw broad market gauges fall over 20% in a single day. To counter inflation, the Fed would raise rates materially in 1989, from 6.5% to 9.75%. The S&P 500 would fall just under 20% from July 16th to October 11th, 1990. The economy would weather a short-lived recession between July 1990 and March 1991. The overlapping Savings and Loan crisis would see the Fed need to cut aggressively cut rates from 1990 through 1992. Supportive monetary policy mitigated the economic recession and stock market correction in this episode.
The bond markets believe that short-term rates, the part of the curve most directly controlled by the Federal Reserve, will be meaningfully lower over time. When the yield curve inverts and bond market participants are willing to accept lower average compensation for longer dated bonds, they believe that short-term bond investors will be reinvesting their maturity proceeds at lower rates in the future. Lower future interest rates have tended to be a sign of future market stress.
In the 2000 and 2007 scenarios, the Federal Reserve was still hiking rates after the bond market inverted, signalling concern over inflation when the market was concerned about decelerating growth that tends to be disinflationary. You are very unlikely to see the Fed lift rates in the near-term. The market is indicating that the Fed is already behind the curve in easing policy. In each of these examples, stocks made new highs after the first appearance of the 2s-10s inversion. Market participants should hope that the 2019 cuts are remembered as mid-cycle like the insurance cuts in 1998. The Fed does not have the same level of monetary firepower that it had during the early 1990s recession. Whether the Fed can successfully extend the cycle is uncertain, but I hope this article illustrates the market conditions around the first points of inversion for the 2s-10s slope in the last three cycles.
Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties, and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.
Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.