What a Yield Curve Inversion Means for Investors

The trickle of headlines about a yield curve inversion has turned into a steady stream of late as investment experts warn about the possibility of recession. The yield curve is the difference between short- and long-term bond yields, and an inversion of the curve has a history of preceding recessions.

An upward-sloping curve often reflects optimism that the economy is growing and should continue to expand. With an inverted yield curve, interest rates on longer-term bonds fall below those of shorter-term bonds, signaling that investors believe future economic growth will lag present levels. When this happens, recessions have often followed. In fact, every recession over the past 60 years has been preceded by an inverted yield curve. With that in mind, does the recent yield curve inversion point to an imminent downturn in the economy? Not necessarily.

How to read different yield curves

First, there are many yield curves. For example, the 10-year Treasury less the 2-year Treasury (which is the curve most often cited as a recession indicator) briefly inverted at the beginning of April. But the 10-year minus the 3-month Treasury (another frequently cited recession indicator) remained positive. Which yield curve should you watch? That’s a point of ongoing debate. Often the 10-year, 2-year inverts before the 10-year, 3-month yield curve. However, the lag between the inversions can vary significantly, further confirming that a yield curve inversion often precedes a recession but offers little as a predictor of timing.

Second, during the Great Recession, the Fed had lowered the short-term Federal Funds rate to 0 percent but still wanted to do more through monetary policy. Instead of going down the road of negative interest rates, the Fed decided to initiate Quantitative Easing (QE) to support the housing and credit markets by purchasing mortgaged-backed securities and longer-term Treasury securities. Ultimately, these bond purchases led to lower long-term interest rates. Simply put, since the Fed has purchased trillions of dollars in Treasury securities, many believe the 10-year Treasury today may be at an artificially low yield, which means the recent yield curve inversion may be less useful as a recession indicator.

Furthermore, yield curve inversions have had false positives, and often the lag between the inversion and the recession can be anywhere from a few months to up to almost three years in the future. Since 1976, the average length of time between an inversion and the start of a recession was 16 months.

Finally, from an investing perspective it’s far from a perfect indicator. While volatility often follows a yield curve inversion, it is important to note that only once since 1976 have stocks posted negative returns for the one-year period following a yield curve inversion. Additionally, bear markets also tend to substantially lag yield curve inversions, with the average length of time between a yield curve inversion and the start of a bear market being 53 months.

While yield curve inversions often precede recessions, it does not necessarily mean a recession or a bear market is imminent.

A good illustration of this is the yield curve inversion that occurred in December of 1988. It took 19 months and a second yield curve inversion before a recession arrived in the summer of 1990. The recession turned out to be mild, and the S&P 500 at its lowest point during the recession was still almost 14 percent higher than when the yield curve inverted. More importantly, an investor who sold when the yield curve inverted in 1988 missed one of the greatest stock market expansions in history; the S&P 500 returned almost 640 percent from the date of the yield curve inversion to the peak before the next bear market in March of 2000.

Don’t overreact to a yield curve inversion

It is important to remember that a yield curve inversion does not cause recessions — it is simply a representation of investors’ expectations about the U.S. economy.

The yield curve is a piece of the puzzle and contains important information. However, it is only one element of a larger picture. Yes, a recession is likely at some point in the future, but whether it comes as soon as four months from now (like the March 1990 yield curve inversion) or 33 months from now (like the June 1998 inversion), utilizing a well-constructed, diversified portfolio in conjunction with a robust financial plan can help eliminate the fear surrounding yield curve inversions and help you navigate market uncertainty.

If you’re concerned about how a recession could impact your financial plan, you should have a conversation with your advisor. However, it’s important to remember that a financial plan prepares you for both the good times and for downturns. While a downturn is possible, there’s also a chance that the market may not move lower than where it is today. Either way, your plan should give you confidence that you’re ready for a potential downturn if it happens. Now is the time for prudence, not retreat.

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