Recently, on 25th March 2019, markets started panicking due to the yield curve inverting, where the 10-year yield dipped below the 3-month yield.
Markets started fearing a looming recession.
Why does this spark fear of a recession?
Normally, yield curves should all slope upwards. This is because, all things being equal, people would demand higher interest rates for longer duration loans. Given that longer-term loans have various risks involved when lending (e.g. inflation risk) and the risks gets riskier over longer time horizons.
So for the curve to invert implies that investors are forecasting that something unusual will happen. Something that will push future interest rates down low enough to justify long-term yields being low despite the risks. Something like the FEDs reducing interest rates to spur economy activity.
In other words, a future recession.
What do I think of this yield curve inversion
While this article is a little late, I thought I share my thoughts on this yield curve inversion.
Yield curve inversions happen well in advance of a recession.
While a yield curve inversion has been a strong indicator of a looming recession, it is not something that will be happening in the next few months. History has shown that the lag time between a curve inversion and a recession has been roughly 18-24 months.
Furthermore, this news of a curve inversion is not something new. In December 2018, markets panicked as well due to the inversion of the yield curve. The only difference was back in December, it was the inversion of the 2-year and 5-year yields. Hence, this news of a curve inversion is really not something new.
Should we be running for the hills?
As mentioned above, a recession does not happen immediately as shown by the time lag between a curve inversion and occurrence of a recession.
Looking deeper at some of the past curve inversions:
- Average time between 2- & 5-year yield inversion and 3-month & 10-year yield inversion: nearly 3 months
- Average time between 10yr-3mo inversion and market peak: over 18 months
- Average S&P 500 gain between 10yr-3mo inversion and market peak: over 25%
While it has taken 3 months before the 2- & 5-year yields led to the 3-month & 10-year yields inversion, data has once again shown that it is not time to be selling everything and just be sitting on cash yet!
Such inversions always mistime the arrival of the bear market. Indeed, what tends to happen is that after a yield curve inverts, you get some weakness, but the fundamentals don’t just fall apart.
No one should underestimate the predictive power of the yield curve inversion, nor should we ignore it. Afterall, there is logical sense in why a yield curve inversion indicates a recession.
However, this does not mean it is time to be selling stocks. Firstly, a meaningful part of the curve has yet to invert. Secondly, after such inversions in the past, the market does not top until after a big surge following the inversion. Investors would start saying the famous 4 words, “this time is different”. We should get a sense of euphoria in the market, and markets go through a boom phase before resulting in a large correction.
Ultimately, we do not see such occurrences happening yet. Until we see these things happening, I feel that all the yield curve is just telling us to be careful.