TROUBLE WITH THE CURVE

The yield curve inverted for the first time since 2007. Yield curve inversions have preceded the last 7 recessions.

• Inversions tend to happen when the Federal Reserve raises short-term interest rates yet long-term bond yields decline
  (indicating a growth slowdown).
• While yield curve inversions historically are a good predictor of recessions, such inversions are not an indicator of the duration before a recession nor stock market returns.

On Wednesday, March 20th, the Federal Reserve put rate increases on hold for the year, while also noting it would be stopping the drawdown of its balance sheet this year (the drawdown is the unwinding of the quantitative easing measures put in place during the 2008 recession). As a result, markets lowered their expectations for interest rates and yields on Treasury bonds subsequently declined. For the first time since mid-2007, the spread between 10-year and 3-month portion of the U.S. Treasury yield curve “inverted” on the following Friday, meaning 10-year yield was lower than the 3-month rate, a bad omen for risk markets. By the close, the S&P 500 had suffered a ~2% decline.

When short-term rates are lower than longer-term rates (a traditional, upward sloping curve), banks can lend profitably as they earn a spread borrowing at the short end and lending at the long end. Once the curve inverts, the absence of profitability discourages lending. The resulting tightening in credit conditions contributes to a recession.
A yield curve inversion has happened on 7 occasions over the past 60 years (see chart below and note when the green line crosses 0). And every recession has been preceded by an inverted yield curve. It is little wonder recession fears have resurfaced. While it is impossible to derive reliable statistics from this relatively small sample, inversions do show a strong similarity given they result from a specific setup of monetary policy and the economic cycle. Hence, inversions are likely to produce similar responses from investors and central bankers.

However, there have been “false positives” in prior cycles (e.g. 1998), and the current inversion could be explained away on nuanced central bank policy and global Treasury demand. While we are not in the camp that it is “different this time”, an inversion doesn’t help define either the length of runway between the inversion or the subsequent recession. Additionally, equity markets produced some of the strongest returns in the months and quarters following an inversion. Historically, inversions coincided with a chain of events that ultimately led to a recession. Knowledge of this pattern may cause it to play out faster or slower this cycle, but the time frame should be considered in quarters or years (rather than months).

It’s difficult to gauge in advance the length of time between the present day and the next recession. What we should take away from last week’s market action is that risks continue to rise—and while these risks bear watching—we likely still have some time to prepare.