The Yield Curve Has Inverted, Run For the Hills?

yield curve

by David Lieberman

Managing Partner, Portfolio Manager

Last year one of the players on my 9-year-old son’s baseball team was hit by a pitch in the neck and was removed from the game. While initially scary, after some icing and time on the bench he was physically fine. Mentally, however, the event had a more enduring impact. In all subsequent games and practices, the player was still nervous about being hit by another pitch. From that point for the rest of the season, he had an incredibly difficult time batting; he nearly always stepped out of the batter’s box with one foot even before the ball left the pitcher’s hand, which made it very difficult to hit the ball properly or with any force. Not surprisingly his hitting suffered. Fear can be a debilitating force pushing us to make poor choices that we wouldn’t otherwise make. It is no different with investing.

Last week the yield curve officially inverted. That is, the yield on the 10-year Treasury bond fell below that on the 2-year treasury. Such inversions have often been cited as a good signal of a coming recession, and the day this happened the bond and equity market reacted sharply. But this is a simplistic view. Inversions have not been consistently predictive, and have frequently incorrectly called for a recession that never occurred. Just a few days ago Janet Yellen talked about the yield curve inversion and said:

“Historically, [the yield curve inversion] has been a pretty good signal of recession and I think that’s when markets pay attention to it but I would really urge that on this occasion it may be a less good signal…. The reason for that is there are a number of factors other than market expectations about the future path of interest rates that are pushing down long-term yields.”1

Yellen added that she doesn’t expect the U.S. economy to go into recession even though the risks are clearly elevated. The Fed already responded by lowering rates once. Current market expectations anticipate another 4 cuts between now and the end of September 2020, so clearly, the Fed is bracing for some weakness but is also prepared to provide some support if it is needed.  (Click here for our economic advisor Alan Greenspan’s opinion as well.)

The trade war that is ongoing is now already 12 months mature and still hasn’t had a major negative impact on the U.S. economy with Q2 GDP holding up at 2%. This also makes sense because the U.S. economy is one of the most dynamic and diversified economies in the world. It’s also largely a self-contained service-based economy that depends far more on what is happening inside the country than out. In fact, the U.S. has one of the world’s lowest shares of imports and exports as a percentage of GDP. All of this reduces the risk and potential impact of a tariff war. Economic data coming into the tariff tiff was also strong and remains solid, even if it has moderated somewhat. This is not to say that the U.S. economy could withstand a full-blown toe-to-toe trade war. But a trade war that plays out slowly spreading out its impact over time does nothing more than creating a slow but steady headwind. We still haven’t seen anything close to the magnitude of trade barriers that would impact the economy negatively enough to lead to an immediate recession.

Getting back to the impact of the yield curve, the inversion itself also isn’t a great indication of the S&P 500 market performance. According to data from the Dow Jones, following the past 5 yield curve inversions, the S&P 500 averaged a 2.5% positive return over the next 3 months from the point of inversion. One year later the return was nearly 13.5% and three years later it was over 16%2.

Whether or not this inversion results in a recession, we can also look at the performance of the S&P during recessions, and here, too, we should be careful not to overreact. In December 2007 the U.S. economy officially went into recession. By the end of the recession in June 2009, the S&P had lost over 35% of its value. That’s the recency bias that still sits front and center on the minds of many investors today – a true baseball to the neck, traumatic kind of memory. It took a full 4 more years for the market to return to its previously attained highs. But the 2008 recession was an aberration for recessions.

Since 1955 there have been 9 recessions, including 2008’s decline. But the average S&P performance during the 9 recessions was actually barely negative. Out of those 9 recessions, 4 had positive returns and the average overall return excluding 2008 was modestly positive.3 In short, recessions don’t always mean negative market performance. Don’t let the extraordinary trauma of 2008 scare you out of the market.

Life events can be scary and can have a lasting impact for decades. And as I’ve written in previous commentaries, humans are built to run when we get scared. Investors that hang on and work through those concerns achieve better overall returns. As for the boy who was hit in the neck when he was 9, he came back with a vengeance this past season and ended up batting clean-up for a good part of the year. Don’t let fear paralyze your behavior or rational thinking. This is true both for investing and in life.

1 https://www.cnbc.com/2019/08/14/janet-yellen-say-yield-curve-inversion-may-be-false-recession-signal-this-time.html

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