There has been a lot of focus recently on the yield curve. For the purposes of this blog, we define it as the spread between 10-year US treasury yields and 2-year US treasuries.
Today it is tracking at ~30 bps, the tightest it’s been since the Financial Crisis.
One would typically expect a positive yield spread since a 10-year instrument has higher risk than a 2-year instrument. For example, investors should demand a premium yield for 10-years vs 2-years. Historically, this spread has averaged 100bps, with a range of roughly -100bps to +300 bps (see chart below).
However, the curve typically “inverts” (e.g., a negative spread) when market participants anticipate an economic recession. Indeed, yield curve inversions have accurately “predicted” economic recessions in each of the past 8 recessions.
But as equity investors, we are (or ought to be) more concerned about stock prices, not necessarily what US (or regional) GDP will be next quarter. What actually happens when the yield curve inverts? We tracked performances of various equity indices and asset classes dating back to 1980 (see below).
Interestingly, there seems to be a pattern in market behavior immediately after a yield curve inverts (please keep in mind every cycle is different and the data are merely averages):
- During the first 3 months, equity markets are sanguine, possibly reflecting a tug of war between bulls (“this is temporary”/”this time it’s different”) and bears (“recession is imminent”).
- Between the 3rd and 6th months, equity markets sell off. In particular, Emerging Markets, Cyclicals, and Small Caps underperform. This makes intuitive sense as defensive sectors like Health Care and Utilities are less exposed to economic conditions.
- Between the 6th and 12th months, market indices actually bounced back, on average closing higher than when the yield curve first inverted. While the timing of a bounce-back could be surprising, a possible explanation for this behavior is that after an initial sell-off, market participants try to “time” and predict a rebound in the economy.
- Only in the most recent 2 recessions—the Dot-com Bubble and the Financial Crisis—did markets take a second, large leg down (-25% in 2002; -35% in 2008), 2 years after the yield curve had inverted (in 2000 and 2006, respectively). See chart below.
We welcome your feedback. Use the comment form below and let us know if you think yield curve inversion is a big deal for equity markets or not.
As international equity investors, the team at R Squared Capital Management (former team at Julius Baer / Artio Global) utilizes fundamental and macro analysis in our quest to correctly identify structural tailwinds and headwinds at the geographic, sector and company levels.
FROM THE DESK OF LUIS AHN
Luis Ahn is a Partner and Analyst at R Squared Capital Management.
Prior to joining R Squared, Luis was a Senior Analyst at Bloom Tree Partners.
Luis received an MBA from The Wharton School and Bachelor of Science in Quantitative Economics and Computer Science from Tufts University.
To view the firm biographies of RSQ, click here.