February 20, 2020
How to Think About Last Year’s Inverted Yield Curve
Regular readers of our Perspectives newsletter know that the investment research team at Greenleaf Trust focuses on leading indicators. One of the better-known leading indicators is the yield curve. In March 2019, the yield curve did something concerning to many investors, it inverted. This article will focus on historical yield curve inversions and highlight our view that, although our antennae are up for risks, this inversion may be different.
What’s a Yield Curve?
The yield curve displays yields for US Treasury bonds of different maturities. Since 1962, an average yield curve has looked like this:
Bonds that mature sooner, in six months or a year, are less volatile than bonds that mature further out into the future. Because they are considered less risky, on average, shorter bonds yield less than longer bonds. That means, on average, the yield curve is upward sloping.
What is a Yield Curve Inversion?
The curve, however, is not always upward-sloping. During times of economic uncertainty, investors seek to “lock in” income by buying longer-term bonds. During such times, investors may also be projecting that the Federal Reserve will lower interest rates to stimulate the economy in the future.
This pattern causes the yield curve to invert. When that happens, short-term yields are actually higher than long-term yields. Since 1962, this has happened ten times in the US, including in 2019. Prior to 2019, a recession followed a yield curve inversion in 7 of the 9 instances, with the start of the recession 4 to 24 months after the inversion. The next chart shows how the curve looked during the last few inversions.
In March, 2019, the curve inverted for the first time during this record-long expansion. It stayed inverted from May through October of last year.
Inversions, Recessions, and Stock Market Performance
So, yield curve inversions are considered “bad.” The stock market must have fallen since March, right? Wrong. The S&P 500 has returned roughly 20% since. The following chart shows the timing of historical yield curve inversions, the timing of recessions, and stock market performance in the 18 months after each inversion.
Out of the ten historical yield curve inversions (including 2019), US stock market performance was positive following 6 (60%) and negative after 4 (40%).
What is Different about this Inversion
In our year-end seminar, we argued that the 2019 yield curve inversion seemed more like 1998 than a “typical” inversion to us. That is important, because 1998 was one of the two historical “false positives” when the yield curve inverted, but a recession did not follow.
The following chart shows why we sense hints of 1998. On average, the curve inversions prior to 2019 happened after 3 month (short-term) yields rose much more quickly than 10-year (long-term) yields due to tightening monetary policy. However, in both 1998 and 2019, the dynamic was different. The larger contributor in both cases was falling 10-year yields, not rising short-term yields.
The Federal Reserve, through their impact on short-term yields, typically has a lot of influence over yield curve inversions. Their response after the curve inverts also seems to matter significantly.
The Monetary Policy Response
One other reminder of 1998 is the way Federal Reserve Chairman Jerome Powell has characterized the monetary policy response over the last year. The Fed had been on a slow path of raising interest rates when they reversed course and cut rates 3 times in 2019, 0.25% each in July, September, and October. Fed Chair Powell described these decisions as a “mid-cycle adjustment” to monetary policy. After the final cut, the curve was no longer inverted, and has remained upward-sloping since.
| Inversion Date | Fed Policy After Inversion | Recession Outcome |
| Sept. ’66 | One 0.25% hike, then about 1.5% of easing. | No Recession |
| Dec. ’68 | Hikes of roughly 3.00%. | Recession begins Dec. 1969 |
| June ’73 | Hikes of 2.25%. | Recession begins Nov. 1973 |
| Nov. ’78 | Hikes of roughly 4.00%. | Recession begins Jan. 1980 |
| Apr. ’81 | Hikes of roughly 3.25%. | Recession begins Jul. 1981 |
| Mar. ’89 | Easing of roughly 1.75%. | Recession begins Jul. 1990 |
| Sept. ’98 | Easing of roughly 0.75%. | No Recession |
| Apr. ’00 | Hikes of roughly 0.50%. | Recession begins Mar. 2001 |
| Jan. ’06 | Hikes of roughly 1.00% | Recession begins Dec. 2007 |
| Mar. ’19 | Easing of roughly 0.75%. | ? |
Examining the historical record, the Fed has commonly shrugged off an inverted yield curve and continued tightening monetary policy. 1998 was different. The Fed cut rates by 0.75% and a recession didn’t begin for an additional two and a half years, after the curve had inverted again in April of 2000.
The monetary policy response in this cycle has been very similar to 1998. The Fed eased and has communicated an expectation that rates will be kept stable at the current 1.50-1.75% range for 2020. We believe this policy response has extended the current business cycle.
Looking Forward
We continue to believe that the yield curve is a powerful leading indicator, but it is not all-powerful. This article examines some reasons to think that last year’s inversion may not be a harbinger of recession. As we set our expectations for markets and the economy, we do not limit ourselves to one, or even a few, indicators of previous business cycles. Instead we examine dozens and attempt to form a holistic outlook.
As of this writing, our assessment is that the slow and steady growth we’ve seen in this record-long expansion can continue, despite the warning signal sent from the yield curve last year. As always, we will keep you updated as our thinking evolves. Please feel free to contact a member of your dedicated client centric team if you would like to discuss these ideas further.