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Brian Levitt | March 29, 2022

What could a yield curve inversion mean for stocks?

Among the most meaningful tips I received in my young career is that of all the indicators that signal what the economy may do next, the bond market gets it right most often. Thus, when the U.S. Treasury yield curve meaningfully flattens, I pay attention. Every recession over the past 60 years has been preceded by an inversion of the yield curve.1

What’s the yield curve telling us now?

As I write this, the spread between the 10-year U.S. Treasury rate and the 2-year U.S. Treasury rate is only 22 basis points, and the forward curve suggests that the 2s/10s spread may be inverted within a matter of weeks.2 Is it time to call the imminent end to the current business cycle and to meaningfully reduce our equity exposure? Not so fast. An inversion of the yield curve is a warning signal of future economic woes. Over the past six decades, the median amount of time between the initial inversion of the yield curve and the onset of a recession is 18 months.3 While a good indicator of future economic woes, an inverted yield curve has not been a very good timing tool for equity investors. For example, investors who sold when the yield curve first inverted on Dec. 14, 1988, missed a subsequent 34% gain in the S&P 500 Index.4 Those who sold when it happened again on May 26, 1998, missed out on 39% additional upside to the market.5 In fact, the median return of the S&P 500 Index from the date in each cycle when the yield curve inverts to the market peak is 19%.6

Historically, stocks have continued to rise even after the yield curve inverts

Sources: National Bureau of Economic Research, Bloomberg, L.P. The S&P 500 Index is a market-capitalization-weighted index of the 500 largest domestic U.S. stocks. Indices cannot be purchased directly by investors. Past performance does not guarantee future results.

Where do we go from here?

The current shape of the yield curve is a signal of what we already believe — inflation is too hot, and growth is going to moderate, albeit from a very robust pace. In my view, recession talk is premature, with household net worth up 17% over the past year,7 retail sales up 18%,8 and industrial production up 8%.9 Nonetheless, we recognize that the cycle is unlikely to last for as long as once hoped. Other great advice received in my youth is to not fight the Fed. Inflation hastens monetary policy tightening which hastens the end of cycles, plain and simple. That said, the Fed is behind the curve and will likely not drive the federal funds rate above long rates until the beginning of 2023 at the earliest.

So, there’s likely time, although the risks are rising. Equity investors should be mindful to not overreact when the yield curve first inverts. It’s a red flag, but not a great near-term timing tool. As someone once advised me, it’s not the first rate hike of the cycle that typically matters for equities, it’s usually the last one.  

1 Source: National Bureau of Economic Research, Bloomberg, L.P. The yield curve is represented by the spread between the 2-year and 10-year U.S. Treasury rates.

2 Source: Bloomberg, L.P., 3/22/22

3 Source: National Bureau of Economic Research; Bloomberg, L.P.; Invesco

4 Source: Bloomberg. L.P. Performance is from the initial inversion of the yield curve on Dec. 14, 1988, to the cyclical market peak on July 16, 1990. Past performance does not guarantee future results.

5 Source: Bloomberg, L.P. Performance is from the initial inversion of the yield curve on May 26, 1998, to the cyclical market peak on March 24, 2000. Past performance does not guarantee future results.

6 Source: Bloomberg, L.P. Past performance does not guarantee future results.

7 Source: Federal Reserve, 12/31/21. Latest data available.

8 Source: U.S. Census Bureau, 2/28/22

9 Source: Federal Reserve, 2/28/22

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Header image: Denni Van Huis / Stocksy

Some references are U.S. centric and may not apply to Canada.

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All investing involves risk, including the risk of loss.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.

An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield. A flat yield curve is one in which there is little difference in the yields for short-term and long-term bonds.

The federal funds rate is the rate at which banks lend balances to each other overnight.

A basis point is one hundredth of a percentage point.

Yield spread is the difference between yields on differing debt instruments, calculated by deducting the yield of one instrument from another.

The S&P 500 Index is a market-capitalization-weighted index of the 500 largest domestic U.S. stocks. Indices cannot be purchased directly by investors.

The opinions referenced above are those of the author as of March 23, 2022. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.