Inverted US yield curve: What does it mean for markets?
17:33, 19 May 2022
An inverted US Treasury yield curve, where short-term Treasuries yield more than long-term Treasuries, has consistently predicted an economic recession over the past 50 years, and we are now nearing a key juncture.
Currently, the 10-year Treasury yield in the United States is a few basis points higher than the two-year yield at the end of March 2022, the lowest level since the Covid-19 pandemic started.
What does a possible inversion of the yield curve mean for important asset classes, including the stock market, gold and the US dollar? When the Treasury curve inverted in the past, how did these assets react?
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An example of an inverted yield curve
What is the Treasury yield curve and when does it become inverted?
The yield curve plots the current yields on bond instruments such as US Treasuries based on their respective maturities (e.g. 3 months, 2 years, 5 years, 7 years, 10 years and 30 years).
The slope of the Treasury yield curve varies regularly throughout time, as yields shift in relation to underlying economic conditions,
A positive sloping (or steep) yield curve occurs when longer term yields are higher than shorter term yields to reflect normal economic conditions. A yield curve gets flatter when short-term yields align to longer-term yields.
The yield curve becomes inverted when investors lose confidence in future economic prospects, anticipating weaker growth and lower interest rates, and prefer to shift their demand toward longer maturities, compressing yields, while selling shorter maturities and generating higher yields on the short end of the yield curve.
Typically, the market looks at the spread between the 3-month and 10-year Treasury instruments, or the spread between 2 years and 10 years to signal the inversion of the yield curve.
Eight yield curve inversions have occurred since World War II and all of them were followed by a recession within two years.
|Yield curve inversion date||Start of NBER|
|December 1968||December 1969||12|
|June 1973||November 1973||5|
|August 1978||January 1980||17|
|September 1980||July 1981||10|
|June 1998||July 1990||13|
|February 2000||March 2001||13|
|December 2005||December 2007||24|
|August 2019||February 2020||7|
Source: Federal Reserve St. Louis; NBER
US yield curve: Where are we now?
At the end of March 2022, the US yield curve has never been as flat as it is now since the start of the Covid-19 pandemic.
The yield curve is not inverted yet as the 10-year Treasury yields is still a few basis points higher than the 2-year yield.
The 3-month Treasury, on the other hand, continues to have lower yields than the 10-year, while the 5-to-30-year portion of the curve is officially inverted.
Inverted yield curve and the stock market
Stocks often perform well following a yield-curve inversion, according to historical data.
The S&P 500 index returned 1.6% on average after three months of yield curve inversion, 5.5% after six months, 10.2% after one year, and 16.5% after two years.
The most recent yield curve inversion, which occurred in August 2019, was among the most beneficial for the performance of the S&P 500 index, which delivered a 19.7% return the following year despite the enormous volatility of the pandemic's initial months.
The increased fiscal and monetary stimulus that helps the economy's recovery from the recession may be one of the causes for the stock market's positive reaction following the inversion.
S&P 500 returns following US yield curve inversion
Inverted yield curve and gold
Historical analysis shows that investors do not like to rush to buy gold in the months immediately following the inversion of the curve.
The average returns of gold after 3 months from the inversion of the curve are negative (-3.35%), and only in one case (after the inversion of the curve in December 2005) gold has given positive returns after 3 months.
Returns after 6 months are slightly positive (0.7%), after 1 year they stand at 7.3% and after 2 years at 34%.
There is one fact to note, however, that the average returns of gold are influenced by the stellar performance that the precious metal had in the months following the inversion of the US curve in August 1978. In that case, gold had rallied for reasons related to rampant stagflation and the inability of the Federal Reserve to contain inflation hikes through interest rate hikes.
Excluding that episode from the analysis, the average returns at 6 months are still negative (-2.6%), and even at 1 year they are negative (-0.65%), while after 2 years they stand at 6.1%.
Gold returns following US yield curve inversion
Inverted yield curve and the US dollar
Historical analysis shows mixed performance of the dollar in the periods following the curve inversion.
The average returns of the US dollar index (DXY) are only slightly positive at 3 and 6 months and after 1 and 2 years from the inversion of the curve.
However, even in this case there is an episode that significantly distorts the result, and we refer to the extraordinary performance of the dollar after the inversion of the curve after September 1980.
The dollar in that case did not react positively to the yield curve inversion per se, but rather to the tight monetary stance induced by Governor Paul Volcker.
Excluding the post-September 1980 dollar performance from the analysis, we obtain minimally positive 3- and 6-month average returns, 0.38% and 0.15%, respectively, and negative returns, -1.6% and -3%, respectively at 1 and 2 years.
US dollar returns following US yield curve inversion
Inverted yield curve and cross-assets performance: conclusions
Looking at the performance of major asset classes after the yield curve inversion event, we see that risk assets (such as equities) tend to offer better returns than safe havens such as the dollar and gold.
In particular, the S&P 500 shows an average performance of 1.6% at three months, 5.6% at six months, 10.2% at one year and 16.5% at two years.
Gold, if we exclude the post-August 1978 parenthesis, shows an average performance of -2.8% at three months, -2.6% at six months, -0.65% at one year and 6.09% at two years.
The dollar, excluding the post-September 1980 parenthesis, shows an average performance of 0.4% at three months, 0.2% at six months, -1.6% at one year and -3.1% at two years.
The positive performance of equity markets could be explained by the fiscal and monetary stimulus that tends to accompany an economic recession and that would push investors to anticipate the recovery of the cycle.
In any case, remember that the past predictive results of the US yield curve do not guarantee similar accuracy in the future.
Before investing in any asset, always do your own research or contact your financial adviser before arriving at a decision. Remember that your decision should be based on your attitude to risk, your expertise in this market, the spread of your portfolio and how comfortable you feel about losing money. Never invest more than you can afford to lose and keep in mind that past performance is no guarantee of future returns.
Markets in this article
US Dollar Index