If you look at the statistics, the #1 way a US yield curve inversion can hurt your portfolio is if it makes you reflexively sell stocks. History shows that, on average since 1960, after an inversion of the 2y/10y yield curve the S&P 500 returns 29% before it peaks. After an inversion of the 2y/5y curve – which is what happened last week – the average return over the next 12 months since the end of 1987 has been 26%.
Answering her final question at her last FOMC press conference a year ago, former Federal Reserve Chair Janet Yellen said, "There is a strong correlation historically between yield curve inversions and recessions. But let me emphasize the correlation is not causation."
Last week, investors appeared to ignore Yellen’s parting words. For the first time in more than a decade, part of the US yield curve inverted. Two- and three-year Treasury yields both closed above five-year yields, contributing to the S&P 500’s 3.2% fall on 4 December and sparking fears that the inversion means a recession is imminent.
But we see a number of reasons why equity investors have better things to worry about than the yield curve:
1. A slight mid-curve inversion has proved pretty meaningless historically. The 2y/5y and 3y/5y parts of the curve inverted as longer-term rates decreased faster than short-term rates. We thought this would happen at some point in the next 12 months; it just happened sooner than we anticipated. Historically, the 2y/10y and the 3-month/10y spreads have both been better indicators of an approaching recession. These remain positive (14bps and 47bps respectively), and we don’t expect either to invert.
2. The inversion doesn’t reflect excessively tight policy. We'd be worried if the move indicated overly tight monetary policy, but the inversion is actually the result of more dovish signals from Fed Chair Jay Powell, who recently said rates are now "just below” a level of interest rates that would be considered “neutral,” suggesting that rates might be approaching their peak.
3. Lower oil prices have played a role, and they should be helpful for consumption. The 30% drop in crude oil prices since an early October peak has contributed to the rally in long-term bonds. Lower oil prices aren't a bad thing for the US consumer, as gasoline bills drop, and they should make it easier for the Fed to justify taking its time with further rate rises. Core PCE, the Fed’s preferred inflation measure, dipped to 1.8% in October.
4. Technical factors, unrelated to fundamentals, are also at play. Many bond investors were positioned the wrong way for more dovish Fed commentary and had to cover. Short positions in long-maturity Treasury bond futures recently reached their most extreme levels since 2010. Falling yields prompted short covering.
5. Even if 2y/10y did invert, this would not point to an imminent recession. On average, recessions start 21 months after an inversion, within a range of 9–34 months.
6. Nor would it be consistent with an imminent bear market. Since 1960, the S&P 500 has rallied an average of 15% in the 12 months before the 2s/10s hits zero. And S&P 500 returns have averaged 29% from the point that the curve inverts to the subsequent equity peak.
7. In any case, recessions don’t happen just because the yield curve inverts. Recessions happen when consumer and corporate behavior changes. So what's important to focus on is whether we're seeing weaker bank lending, or reduced consumer/corporate borrowing and spending. Some sectors have been impacted: auto sales peaked in 2016 and recent housing data has disappointed. But banks are not reporting that corporate loan growth has weakened, and the Fed’s Senior Loan Officer Survey shows that lending conditions are still easing.
We are continuing to monitor these and other potential factors of concern: the developments in the US-China trade conflict, Italy's fiscal probity, central bank policy, inflation, the US housing market, Chinese economic data, rising government and corporate debt, and widening credit spreads. We just don't think the yield curve inversion is, itself, one of them.
On balance we regard the economic outlook as positive enough to support a tactical overweight on global equities, although we also hold countercyclical positions, including a long in the 10-year Treasury bond, to help hedge against downside risks.
If you look at the statistics, the #1 way a US yield curve inversion can hurt your portfolio is if it makes you reflexively sell stocks. History shows that, on average since 1960, after an inversion of the 2y/10y yield curve the S&P 500 returns 29% before it peaks. On balance we think the economic outlook is positive enough to support a tactical overweight on global equities.