3 things to know about the inverted yield curveContributor Alex Dryden
Last week a closely watched economic indicator, the yield difference between the 3-month T-bill and the U.S 10-year inverted. Why does this matter? Normally a yield curve is upwards sloping as long-dated bonds are inherently more risky than short-dated bonds due to the risks associated with time. An inverted yield curve is where yields of short-dated bonds rise above the yields on long-dated bonds, historically this has been a sign of an impending recession. There are a few factors investors should consider about the recent inversion:
1. Growth concerns are flattening the curve
The yield of U.S. government bonds is essentially a function of growth and inflation outlook, should investors begin to change their view on either of these factors yields can begin to move. As we highlight in the below chart, investors have dramatically downgraded their view on economic growth over the course of 2019. This has seen the U.S. 10-year yield fall from over 2.74% in December 2018 to 2.45% in March 2019, dramatically flattening the yield curve.
2. The Fed has paused its rate hiking cycle
Historically, an inverted yield curve means that a recession is looming. However, there have been incidents in the past where parts of the yield curve have inverted and a recession has not followed – one of those exceptions was in mid-1998. One major factor that contributed to this false positive was that the Federal Reserve (the Fed) paused their rate hiking cycle and therefore relieved pressure off the front-end of the curve and a recession did not occur for nearly three years. With the Fed on pause in 2019, investors should consider whether this may be similar to the 90s and that an inverted yield curve might need to be taken with a grain of salt.
3. Investors should proceed but with caution
So how should investors react to an inverted yield curve? Historically, equity returns post-inversion are quite strong, since the 1970s once the 3-month T-bill and the U.S. 10-year inverted it took on average another 350 days before the equity market peaked, returning on average 22% during that period. With that in mind investors shouldn’t immediately change their portfolios however, a slightly more cautious stance at this late stage in the cycle may be warranted.
Decomposing change in yields: growth and inflation
Basis points, through March 2019