Ever since Dec. 3, 2018, when the yield curve inverted (with the yield of 2.83% on the five-year Treasury note 1 basis point lower than the yield of 2.84% on the three-year Treasury note), I have been receiving calls and emails from worried investors about the impact of an inverted yield curve.
The reason they worry is the much-publicized relationship between inversions and recessions—inverted curves have predicted all nine U.S. recessions since 1955. You can observe the relationship in the following chart from WealthManagement.com, which shows the yield spread between two-year Treasury notes and 10-year Treasury notes during the most recent recessions (shaded in gray).
Recent history shows that a recession follows yield curve inversion in an average of 16 months, and the setback lasts, peak to trough, for an average of 12 months. The question is, should you be worried about the inversion?
Before tackling that issue, it’s worth noting that, on Dec. 3, 2018, the S&P 500 Index closed at 2,790. On April 3, 2019 it closed at 2,873, a gain, not including dividends, of about 3%. It’s also worth noting that, given concerns about a slowdown in global economic growth, on March 20, 2019, the Fed announced it does not expect to raise rates further this year. That said, should you be concerned, or acting, based on the recent inversion?
Should You Care?
To begin, it is important to understand that what matters is not just the relative level of interest rates, but whether the Fed’s policy is accommodative or contractionary. The reason we have experienced recessions after inversions is that Fed policy was contractionary as it tried to fight inflationary pressures. By raising real interest rates to levels sufficient to slow demand and fight inflation, the Fed can cause a recession.
With this understanding, we should ask whether Fed policy is currently in a contractionary or accommodative regime. When it comes to monetary policy, it is the level of real interest rates, or the inflation-adjusted federal funds rate, that matters.
On average, the real federal funds rate is positive. Over the last seven decades, it averaged about 1.3%. We fell well below that level in January 2008, when the Fed slashed rates to try to prevent a depression. The Fed has kept policy accommodative since then. The latest forecast from the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters is for inflation to be 2.0% in 2019. With the current three-month Treasury bill rate at 2.42%, we have a real three-month Treasury bill rate of just 0.42%, well below the historical average of 1.3%.
Clearly, monetary policy is still accommodative and supportive of economic growth. As long as the real federal funds rate remains at relatively low levels and the nominal federal funds rate is basically flat relative to the five-year and 10-year Treasury notes, investors should temper any concern they have about an inversion in the yield curve.
In addition to relatively loose monetary policy, we also have massively stimulative fiscal policy, with the budget deficit at about $1 trillion. That doesn’t mean a recession isn’t possible, as one can be caused by exogenous events, but it isn’t going to be caused by monetary or fiscal policy that is too tight.
It’s also worth noting that while the curve inverted in December, the new claims for unemployment, at 202,000, just hit the lowest level since December 1969 (almost 50 years ago); employment rose 196,000 in March (producing a three-month average of 180,000); and average hourly wages for private-sector workers grew 3.2% from a year earlier!
Another reason you shouldn’t focus on the slight inversion we have experienced relates to the fact that the flattening of the yield curve has mostly occurred at the longer end. While U.S. interest rates are well below historical levels, they are now well above those of most other developed countries. For example, the yield on 10-year U.K. gilts is just 1.08%. The yield on 10-year German bunds is slightly negative, at -0.01%. The yield on Japanese 10-year government bonds is also slightly negative, at -0.05%.
Those low yields have led to the U.S. Treasury bond market attracting capital, suppressing our longer-term yields and flattening the curve. Normally, a flattening of the yield curve might signal the market is expecting weaker economic growth. However, today that flattening could just as likely be a result of “safe-haven demand” (capital flows to the U.S., as our economy is less likely to be negatively impacted by a trade war) and the global search for higher yields.
There’s one other important point to remember: If the yield curve inverted further due to a weakening of the economy, it is likely that Fed policy would become even more accommodative, reducing the risks of a recession and a bear market.
As the advice I offer is always based on the evidence, let’s now turn to the evidence on stock returns following inversions.
Stock Returns Following Yield Curve Inversions
In an August 2018 article, “What Does a Yield Curve Inversion Mean for Investors?”, Dimensional Fund Advisors examined the returns to stocks following inversions for five major developed nations, including the U.S., since 1985.
The article states: “Equity returns (as measured by MSCI local currency indices) were a mixed bag in the three years following an inversion, with US index returns higher 66% of the time at the 12-month mark and only 33% of the time 36 months later. When all countries are included, returns of the indices were higher 86% of the time 12 months later and 71% of the time 36 months later.” Dimensional concluded: “It is difficult to predict the timing and direction of equity market moves following a yield curve inversion.”
My colleague, Jared Kizer, also took a look at returns following yield curve inversions. He examined inversions, defined as the spread between two- and five-year Treasuries, and found that the three years following one produced a total market beta premium of just under 3%, and the five years following one produced a total market beta premium of almost 11%.
Jared also noted a very wide range of outcomes for the market beta premium over both horizons, but particularly for the five-year period. Among five-year periods, four results had negative total returns (although two of these overlap), with two of them being negative total returns in excess of 30% (the largest negative total premium was -42%).
However, in some five-year periods, the total market beta premium was substantially positive, with a few results in excess of 50% (the largest was 69%). In other words, U.S. stock market returns have tended to be lower than their historical average, but still positive, following periods of yield curve inversion.
The bottom line is that, while an inverted curve may be a reliable indicator that a recession is likely to begin, on average, within 16 months, it is not an indicator reliable enough to allow you to profitably time stock markets.
That should not come as a surprise, as there is no evidence that active managers have been able to exploit any signal provided by well-publicized information on the predictive nature of yield curve inversions. If there were any evidence, we would see it in the annual S&P Dow Jones Indices versus Active (SPIVA) scorecards. But none exists, in either the stock or bond market.
Remember, if information is well known, any predictive value it contains is already built into current prices. Thus, it’s unlikely you can use it to generate outperformance. Investors fail to differentiate between information and value-relevant information, trading on what is nothing more than information that has no value. Certainly, if you hear it on TV or read it in the newspaper, it is far too late to act on it.
There will always be something for investors to worry about, which is why Warren Buffett warned that once you have ordinary intelligence, success in investing is determined far more by temperament—the ability to ignore the noise of the markets and adhere to your well-thought-out plan that incorporates the risks of negative events.
Hopefully, your plan reflects the certainty that negative events, including nonforecastable Black Swan events, will occur with a high degree of regularity and ensures you are not taking more risk than you have the ability, willingness and need to take. Getting that right increases your ability to ignore the noise of the market and raises the odds that your head, not your stomach, will be making investment decisions. I’ve yet to meet a stomach that makes good decisions.
Lastly, ask yourself this question: Is Warren Buffett spending even one minute worrying about a yield curve inversion? The answer almost certainly is no, because he has said he hasn’t even looked at, or listened to, an economic or market forecast in more than 25 years. One of the great anomalies in finance, which I point out in my book “Think, Act, and Invest Like Warren Buffett,” is that while investors idolize Buffett, they not only fail to follow his advice but often do the exact opposite, to their great detriment.
Summarizing, the strategy most likely to allow you to achieve your financial goals is to develop and adhere to a long-term plan in line with your ability, willingness and need to take risk. By doing so, you will be better able to look past the noise of the market and focus on investing in a systematic way that will help you meet long-term goals.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.