Un-Inversion
Last week, the yield curve “uninverted.” This historically has signaled an incoming recession.
What the heck is an “un-inversion?”
Let’s start out with a “normal” yield curve. When you invest your money in a normal yield curve market environment, you get a higher return when you agree to tie up your money for longer. For example, if I am willing to tie up my money for 10 years, the bank will give me a higher return (e.g. higher yield or higher interest rate) than if I purchase a 2 year CD. I’ve taken on more risk, and they reward me with a higher rate of return. This same situation usually exists with US Treasury bonds. If I buy a 10 year bond, I usually will get a higher rate of return than if I buy a 2 year bond. The chart below shows this normal yield curve at the end of 2021. A 30-year bond paid 1.9%, better than a 10 year bond at 1.5%. And a 10-year Treasury bond paid 1.5% while a 2-year Treasury provided a .75% return.
What, then, is an inversion? Over the past two years, until last week, the 2-year Treasury provided a better return than the 10-year Treasury. Thus the financial jargon that the yield curve was “inverted.” This inversion of the yield curve is usually a sign of stress in the economy. The details of that stress are often unclear, but the inversion generally is the most predictable signal that something isn’t quite right. You will notice in the chart below from June of this year that the 2-year Treasury returned 4.67% while the 10-year Treasury returned 4.2%. This curve from June happened to be deeply inverted, with short-term rates (1 month, 3 month, up to 1 year) all providing better than 5% return with longer-term rates all less than 4.7%:
What is an “Un-Inversion”? The yield curve, as measured by the 2-year and 10-year Treasury, officially un-inverted, albeit slightly, in the past week. The 10-year return moved above the 2-year return. As I type this, the 10-year rate is 3.7% with the 2-year rate at 3.6%:
If the inversion of the yield curve is a sign of stress in the economy, the un-inversion is generally the signal that the recession is close at hand. Should we be scared, then, of the un-inversion?
We haven’t had a recession in roughly 15 years (the 2 month COVID recession is not counted given the uniqueness of the event and the resulting government stimulus). The 15 year gap between recessions is atypical. Since the end of WWII, there have been 12 recessions, or on average, one every ~7 years. The average length of these recessions was about a year. A different way to slice this 79 year time period is that 85% of the time, the US economy was growing.
And what does un-inversion mean for the stock market? In the two most recent recessions, 2000 and 2007, the market (S&P 500) was down 12 months after the un-inversion. However, in the 1980, 1982, and 1990 recessions, the market was up on average 12 months after the yield curve un-inverted (see the thick black line in the chart below):
In other words, even if the un-inversion is a signal that a recession is near, it doesn’t necessarily mean the market will be down 12 months from now.
Because predicting the outcome of un-inversions and recessions is such a difficult job, and especially predicting them with timing precision, the general guidance is to stay invested rather than try to time the market. That said, we certainly realize that risk tolerance is individual, as is the fact that some people need to tap their investments in the near future. In cases where we believe it makes sense to take less risk, we’ve modified portfolios to include stocks that provide downside protection.
I’ve shared similar charts in the past to keep this all in perspective. Today’s version is this amazing chart showing that a $1 invested in 1870 would be worth $19,000 today. That’s despite all the blips from recessions, wars, political scandals, and inflationary bear markets.
Mark Twain once said “history doesn’t repeat itself, but it often rhymes.” If you watch the financial press, they will analyze a thousand different ways whether it’s different this time. Maybe a recession isn’t imminent. Maybe everything is simply getting back to normal. They will cite the uniqueness of COVID and the resulting stimulus, they will talk about inflation, and they will cite the Ukraine war and upheaval in the Middle East.
I believe the more important question isn’t whether a recession is looming. The un-inversion of the yield curve likely signals one is coming. The more important long-term question is whether the US economy will continue to grow 85% of the time. If it does, you can bet the chart above will continue to go up and to the right without any long-term inversion.
Jared
Planning Pays Dividends
* Yield curve charts are from the US Treasury and from Statista.
** The un-inversion chart is from All Star Charts.
*** Growth of $1 chart is from Kaplan/Morningstar Direct
All other YCharts graphs are created by me, Jared Kline.
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