Why An Inverted Yield Curve Is A Bad Tool For Timing The Stock Market


After a brief trip into inversion territory earlier this week, the yield on the 2-year Treasury note climbed above the 10-year yield on Friday, inverting that carefully monitored gauge of the yield curve and tentatively triggering recession warnings.

The 10-year Treasury note yield TMUBMUSD10Y, 2.679 percent, was 2.374 percent on Friday afternoon, while the 2-year yield TMUBMUSD02Y, 2.515 percent, increased by more than 13 basis points to 2.374 percent.

This timing tool isn’t suitable. So, should stock market investors be concerned?

Perhaps not too concerned — at least not because of the curve — for the time being. Economists argue that a prolonged curve inversion is required to convey a strong signal. For another, the curve’s other crucial measurements have yet to invert. Research shows that selling stocks when the yield curve is skewed hasn’t always paid off.

In a March 24 report, Brian Levitt, global market strategist at Invesco, stated, “While a solid signal of future economic troubles, an inverted yield curve has not been a particularly good timing tool for equities investors.”

“Investors who sold when the yield curve inverted for the first time on December 14, 1988, for example, missed a subsequent 34 percent gain in the S&P 500 index,” Levitt said. “Those who sold on May 26, 1998, when it happened again, missed out on a 39 percent increase in the market,” he remarked. “In reality, the S&P 500 index has a median return of 19% from the date when the yield curve inverts to the market peak in each cycle.” (For further information, see the table below.)

The curve didn’t seem to faze INVESCO investors last week. After a brief inversion on Tuesday, U.S. stocks completed the day with big gains and opened the day with small gains after Friday’s latest push into inversion territory. Stock indices had a tumultuous week, but the curve didn’t take much of the blame, if any at all. The S&P 500 SPX, +0.43 percent, gained 0.1 percent for the week, while the Dow Jones Industrial Average DJIA, +0.25 percent, lost 0.1 percent, and the Nasdaq Composite COMP, +0.06, increased by 0.7 percent.

What are inversions, and what do they mean?

Given the time value of money, the yield curve, which measures yields across all maturities, usually slopes upward. An inversion of the yield curve indicates that investors expect longer-term rates to remain lower than short-term rates. This phenomenon is usually seen as a harbinger of an impending recession.

Insights into Investing in a Global Context

Real-time news and analysis can help you understand how today’s global business practices, market dynamics, economic policies, and other factors affect you.

However, there is a latency there as well. According to Levitt, the typical time between an inversion and a recession has been 18 months, which corresponds to the median time between the commencement of an inversion and an S&P 500 peak.

Which curve is it?

According to Ross Mayfield, investment strategy analyst at Baird, an inversion of the 2-year TMUBMUSD02Y, 2.515 percent /10-year TMUBMUSD10Y, 2.679 percent gauge of the yield curve has preceded all six recessions since 1978, with only one false positive.

According to analysts at the San Francisco Fed, the 3-month/10-year spread is considered slightly more reliable and has been more popular among academics. Mayfield pointed out that this curve measure is still “far from inverted.” The 10-year yield is over 1.9 percentage points higher than the 3-month yield.

Some economists say that the Federal Reserve’s bond-buying program has artificially pushed long-term yields low, distorting the yield curve’s signal.

And earlier this month, Fed Chairman Jerome Powell stated that he prefers a more short-term focused measure that compares 3-month rates to forecasts for 3-month rates 18 months in the future.

Two Curves Diverged

For some market watchers, the disparity between the two closely observed curve measurements has been a puzzle.

“What’s interesting is that they’ve always gone hand in hand directionally until around December 2021, when 3m/10s started to steepen as 2s/10s dropped,” said Jim Reid, a Deutsche Bank strategist, in a Tuesday note (see chart below).


“Perhaps because the Fed has never been as far behind the ‘curve’ as they are today, there has never been such a directional divergence,” Reid added. “If market pricing is correct, they will quickly catch up over the following year, so it’s feasible that the 3-month/10-year measure will be flat in 12 months” as short-term rates climb as the Fed raises its benchmark policy rates.

The upshot, according to Mayfield, is that the yield curve is still a significant indication that, at the absolute least, indicates a cooling economy.

“Volatility should continue to rise, and the threshold for investing success should also be raised.” But, in the end, we believe it is worthwhile to consider the big picture rather than relying on a single indicator,” he said.

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