Should You Fear the Yield Curve?

The spread between the 10-yr and 2-yr has now narrowed to 50 bps — the same level it was when stocks peaked in October 2007.  Many take this as a harbinger of financial disaster. Is it?

Flat or inverted yield curves typically signal a recession.  And, it’s hard to argue the point.  Investors would have to be pretty pessimistic if they’d rather tie up their money for 10 years at a rate lower than shorter-term instruments offer.

The yield curve inverted just before the recessions of 1981, 1991 and 2000.  And, it inverted about two years before the 2007-2009 GFC.  But, as the chart below shows, inversions and market peaks haven’t always lined up that well.

In 1998, a brief inversion occurred about two months prior to the 22% correction.  In 2000, we saw the same two month lead time but this time the inversion lasted 11 months and stocks plunged by over 50%.The curve inverted again beginning in late 2005 and bounced around for quite a while before going positive in May 2007.  Five months later, as the curve was rapidly steepening, the S&P 500 peaked and began a 57% crash.

The other significant selloffs since then — Apr-Jun 2010, May-Oct 2011, and May 2015-Feb 2016 — have occurred with positive curves that were either in the midst of flattening or about to flatten sharply.

The current levels are, indeed, equal to those at about the same time as the market peaking in Oct 2007.  But, in 2007 the curve was rapidly steepening.  Today, it is (not quite as) rapidly flattening.  I’ve highlighted a similar move in 2005 (from 1.34 to .57) for comparison purposes.

Note that in 2005 the rate of change was even greater that it has been this past year.  But, it still took another 8 months to invert and another 22 months for stocks to peak.

While admittedly a very simplistic exercise, I believe the above shows that while the potential is there for a recession, this is just an early warning at this time.  If the yield curve bottoms out here and rapidly steepens, we’ll have a lot more to worry about.

Stay tuned.



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