Active is: analysing economic indicators

Should we fear an inverted yield curve?


All US recessions since 1970 have been predicated by a yield-curve inversion – but despite slowing growth, we don’t expect a recession in the next 12 months. Plus, years of ultra-low rates could make this inversion less significant than others. Investors can still find opportunities to earn income and potential return.

Key takeaways

  • Although inverted yield curves have been fairly reliable predictors of US recessions, since 1980, the average lead time from inversion to recession has been lengthy (13 months)
  • Equity markets can do quite well in the post-yield-curve-inversion, pre-recession period: the S&P 500 Index returned 10% on average after four of the last five inversions
  • For nearly a decade, yields have been ultra-low and the yield curve has been relatively flat; this may make inversion less meaningful this time around
  • The “hunt for income” is becoming critical; risk assets may offer attractive income and return potential, and help investors guard against inflation

What’s the relationship between inverted yield curves and recessions?

The US yield curve recently “inverted” – the 3-month US Treasury yield pushed past the 10-year Treasury yield by 7.5 basis points on 27 March – leading many investors to wonder what’s next for the US economy. An inverted yield curve historically has been a fairly reliable leading indicator of a US recession.

The 3-month/10-year curve inversion has historically preceded a US recession

Exhibit 1 

Source: Bloomberg. Data as at March 2019.

When do recessions start after the curve inverts?

On average, since 1980, the average lead time from inversion to recession has been 13 months, with an overall range of 7 to 21 months. Clearly, recessions certainly do not occur immediately after inversions; in fact, the longest post-inversion, pre-recession time period lasted seven quarters. As the accompanying chart shows, since 1980, yield-curve inversions persisted for 7.5 months on average, and the magnitude of inversion was -164 basis points on average.

Of course, it is important to note that the latest yield-curve inversion has lasted only a few days, at the time of writing – averaging -4.0 basis points over four days as at 27 March 2019.

How have stocks performed during inversions?

Equity markets have generally done quite well during the period between inversion and recession. In four of the last five inversions, the S&P 500 Index returned 10% on average. However, during the 2001 inversion, the S&P dropped 14% as the technology sector began to roll over.

Stocks have generally done well after inversions/before recessions

Recession start Time from inversion to start of recession (months) Duration of inversion (months) Peak inversion (basis points) S&P 500 performance, from inversion to start of recession
1 Jan 1980 14.2 12.3 -298 11.5%
1 Jul 1981 8.2 7.2 -373 1.5%
1 Jul 1990 13.2 1.3 -7 11.7%
1 Mar 2001 7.2 4.0 -77 -14.4%
1 Dec 2007 21.4 12.6 -66 15.7%
Average 12.8 7.5 -164 5.2%
Source: St. Louis FRED, FactSet. Data as at March 2019. Recession start/end dates are according to National Bureau of Economic Research.

What does a lower long rate imply?

Generally, while short-term rates are more anchored to the federal funds rate and policy changes, longer-term rates are more determined by the market outlook for inflation, as well as the health of the economy over time. As a result, a falling 10-year Treasury yield can often be a signal that markets anticipate longer-term weakness in the economy, and that they do not foresee inflation as a lingering threat.

Inverted yield curves have also generally been negative for the financial sector – particularly for banks that earn a key income stream from the spread by borrowing short and lending long. Smaller banks tend to be disproportionately hurt in a flattening or inverted yield-curve environment, since they generally don’t have the diversified sources of income that larger banks do.

What could be different this time?

Globally, yields are falling. The amount of US dollar-denominated negative-yielding debt now exceeds USD 10 trillion as global growth slows, central banks revert to easing mode and markets see few signs of inflation. This may help keep US 10-year yields lower, with the global interest-rate environment contributing to distortions in the US yield curve.

Negative-yielding debt is on the rise

Exhibit 3 

Source: Bloomberg. Data as at March 2019.

In addition, given that yields in the US have been held to ultra-low levels for nearly nine years, a yield-curve inversion may not be as meaningful this time around. Former Federal Reserve Chair Janet Yellen said as much at a recent investor conference, noting that “in contrast to times past, there’s a tendency now for the yield curve to be very flat.” She added that this tendency makes it easier for the curve to invert.

Is a US recession coming?

A majority of economists expect US growth to slow this year; US real GDP growth has already been falling, moving from 2.9% in 2018 to 2.4% in 2019, according to Bloomberg consensus forecasts. However, there are few calls for a US recession over the next 12 months.

Indeed, the Federal Reserve – which is one of the more notable forecasting institutions – seems to have the most conservative estimate for 2019 growth, at 2.1%. This still remains above potential output (the estimated maximum sustainable output). According to Bloomberg, most estimates show US economic growth moving downwards next year, towards potential growth of 1.9% in 2020. It is at this level where vulnerabilities may start to rise, particularly if the economy experiences a shock – whether from within US borders or from abroad.

Notably, the inverted yield curve could also have an impact on US consumer confidence – and on investment management firms, particularly those driven by algorithmic models, that trade recession warning signals such as these. As these signals emerge, uncertainty and bouts of panic could increase in the economy and markets, which could ultimately create a self-fulfilling prophecy that sends the economy into a downturn. So far, however, the reaction in risk assets and the broader economy has been relatively tempered.

In her recent comments, Ms Yellen seemed to send a calming message, stating that “yes, growth is slowing, but I don’t see it slowing to a level that will cause a recession. In fact, it might signal that the Fed would at some point need to cut rates.”

What are the potential implications for markets?

Here are three themes for investors to keep in mind.

  1. The “hunt for income” is becoming critical. Lower long-term yields and generally low inflation globally mean that the biggest risk may be to avoid taking risk. Investors should consider maintaining exposure to risk assets as they aim to meet income and return targets, and as they seek to guard against wealth erosion over time. To enhance portfolios, look for strategies that offer the potential for outsize income, both domestically and abroad. In the US, particularly for higher-yielding strategies, we continue to favour shorter-duration assets, and we believe active management is becoming increasingly critical at this point in the economic cycle.
  2. Equities can continue to perform well. In a flattening or inverted yield-curve environment, “growth”-style equities may be valued at a premium as growth becomes harder to find. Look for winners from disruption in areas that have long-term secular stories – including cloud computing, mobile payments and cyber-security.
  3. Global diversification is critical. Consider taking a “barbell” approach to investing in global markets. On one end, the US could be a source of stability in developed markets; on the other end, China and select emerging markets can provide growth potential. If China’s economic stimulus continues making an impact, if the US and China continue moving towards a trade deal and if the US dollar stabilizes, this approach could be particularly attractive. In addition, European dividend yields may become increasingly appealing over time, with the Euro Stoxx 50 index yielding 3.6% and the FTSE 100 index nearly 5.0%.


Active is: Navigating geopolitics

What’s next for India’s “improbable” democracy?

A crowd walks on a street in Varanasi, India


The world’s second-most populous country has launched the world’s biggest exercise in democracy – and reform is on the agenda. Regardless of the short-term noise from these elections, India’s economy looks strong, particularly if the country can take advantage of opportunities arising from US-China trade tensions.

Key takeaways

  • As India holds its month-long general elections, most political parties are talking about “development” and “reform”; this is good news for investors
  • India’s incumbent prime minister has been a partially successful reformer – the goods and services tax is his government’s biggest achievement – but he will need to deliver more if he wins again
  • We are optimistic about India’s long-term economic growth, though infrastructure and employment need attention
  • Long-term investors should consider Indian companies with good governance records, using an active, all-cap approach to access the potential structural opportunity that India represents
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