- The inverted yield curve is a closely watched indicator of recession, but it’s not the only one to watch.
- Previous reversals preceded a recession by nearly two years, making it difficult to use as an accurate indicator.
- It is the further steepening of the yield curve, or disinversion, which is followed more closely by a recession.
Investors love to point to an inverted position yield curve as an infallible signal that the economy is about to enter a recession.
Indeed, since 1960, whenever the 10-year and 2-year U.S. Treasury yield curve has inverted, which occurs when short-term bonds offer a higher yield than long-term bonds, a recession followed.
But the closely watched signal is a poor market timing tool because past reversals preceded a two-year recession. And over those two years, stocks, in some cases, have performed well.
There is another signal that investors should pay close attention to, which has always signaled that a recession is imminent rather than years away.
This sign is when the yield curve rises, or when short and long-term bonds return to the usual pattern of higher yields for longer maturities.
“When the yield curve disinverts, it signals that a recession is closer (within a year based on the last three recessions). While the inversion indicates that trouble is coming in the medium term, the disinversion indicates that problems are coming indoors per year,” Commonwealth CIO Brad McMillan said.
Since the yield curve turned negative in July amid aggressive interest rate hikes from the Federal Reserve, it hasn’t looked back, at least until last week.
The 10-year and 2-year yield curve inverted more than 1% on March 7, the largest inversion since the 1980s. But the fallout from the Silicon Valley Bank collapse led to a sharp decline in interest rates and caused the steepest three-day yield curve steepening since 1982, according to Bank of America.
The yield curve has more than halved its negative inversion at minus 42 basis points this week, and if Fed suspends interest rate hikes and short-term yields continue to fall, a full disinversion of the yield curve would be imminent, signaling that a recession is near.
“The yield curve always steepens in a recession,” Bank of America’s Michael Hartnett said in a Friday note.
This aligns with the thinking of CIBC Private Wealth Chief Investment Officer David Donabedian, who told Insider that “given the banking crisis, we believe a recession is even more likely and could be brought forward. and the extension of credit in the wake of the banking crisis is coming.”
But others are less bearish on the outlook for a yield curve disinversion and potential recession, including Commonwealth Financial Network’s head of portfolio management, Peter Essele.
“While the signal is concerning, it is not quite time to hit the pause button for equities. Advanced economic cycles often produce robust returns for investors. Yields completely reverse as forward yields become a concern, so we caution against selling risky assets at this time,” Essele told Insider.
This reflection echoes that of Fundstrat Tom Lee told customers during a webinar on Thursday.
“I think inflation is broken, which is why the yield curve isn’t inverting. But we really haven’t broken the economy yet.”
Although the yield curve is not yet fully inverted, it is heading in that direction following this week’s banking crisis, and when it does, investors should be prepared for a possible recession and weak stock returns.
Bank of America