Should I be worried that the curve inverted? - J.P. Morgan Asset Management
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Should I be worried that the curve inverted?

Contributor David Lebovitz

With recent comments from the Federal Reserve sounding more accommodative and evidence of a positive turn in trade negotiations, it felt as if equity markets were finally set for some relief. However, investing isn’t that easy, and Tuesday saw parts of the yield curve invert for the first time this cycle. Stocks sold off aggressively in response, as fears over an economic slowdown became front of mind for investors; while we maintain our view that U.S. economic growth is set to slow in the back half of next year, we do not believe recession is imminent. That said, we do believe it is important to understand what has happened in the context of what has historically occurred around yield curve inversions.

To start, it is the 3-month/10-year (3m/10y) curve that has historically been the best predictor of recession. However, it was the 2-year/5-year (2y/5y) and 3-year/5-year (3y/5y) curves that inverted this week. These curves have historically failed to demonstrate the same predictive power as the 3m/10y curve, and have always inverted prior to the more accurate 3m/10y. Furthermore, it seems as there may have been technical factors at play, as the rally in oil led inflation breakevens on the short end of the curve to rise.

This inversion does confirm that the U.S. economy is firmly late cycle, but the risk of recession in the next twelve months remains limited. Furthermore, even the 3m/10y curve is an imperfect indicator, and has historically inverted around the same time as the Fed’s final rate hike, but in advance of the stock market peak, and onset of recession. There have been five inversions of the 3m/10y curve since 1980, but only four recessions. The one false positive occurred in 2006 when the 3m/10y curve inverted for one day, and then moved back into positive territory before fully inverting in July 2006.

The four instances where the 3m/10y yield curve inverted for a sustained period of time occurred on average during the same month as the Fed’s final rate hike, 6 months before the stock market peak, and 11 months before the onset of recession. An inverted yield curve can signal when recession is on the horizon, but does not tell you as much about the timing. While economic growth will slow in the back half of next year, investors have historically benefitted from staying the course even after the curve has inverted; we continue to believe there is upside in equity markets from current levels.

Even the yield curve isn't perfect

Spread between 3-month and 10-year U.S. Treasury yields, percent

Federal Reserve, National Bureau of Economic Research (NBER), FactSet, J.P. Morgan Asset Management. Data are as of 12/5/2018.

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