Our client question of the month relates to the yield curve inversion, what an inversion has historically signified, and what it could mean for the economy and markets going forward.

What is the Treasury Yield Curve?

The Treasury Yield Curve is a graph of a Treasury bond’s yield-to-maturity at various periods typically ranging from 3-months to 30-years. Yield-to-maturity is the estimated annualized rate of return an investor can expect on Treasury security if purchased today and held to maturity.

The Federal Open Market Committee (FOMC) influences the short end of the yield curve by setting the target federal funds rate range.  The current federal funds rate range is 4.75% to 5.00%.  The FOMC’s most recent Summary of Economic Projections (SEP) showed that the median participant expects the federal funds rate to peak at 5.1% in 2023 before they cut rates to 4.3% in 2024.

The market controls the long end of the yield curve based on expectations of economic growth and inflation.  Bond prices move inversely to yields (please see our Client Question: Bond Primer for details).  In general, when the market becomes nervous about economic growth or a recession, there is a “flight to safety” where investors purchase long-term Treasuries (yields move lower and bond prices move higher).  When the market expects strong economic growth and/or high inflation, investors sell long-term Treasuries in search of better opportunities (yields move higher and bond prices move lower).

What does the shape of the yield curve typically look like?

The shape of the yield curve is generally upward sloping where longer-term maturities have higher yields than short-term maturities. According to the Fed, Treasury yields have two components: expectations of the future path of short-term Treasury yields and the Treasury term premium. The term premium usually accounts for most of the upward slope of the yield curve and is defined as the difference an investor would receive for locking up their invested capital for an extended period (i.e. buying a 10-Year Treasury) versus rolling over short-term securities for the same amount of time (i.e. buying a 3-month Treasury Bill every 3-months for 10-Years). The term premium exists because investors need to be compensated for locking up their capital – the longer you lend someone money, the more risk there is for something to go wrong. We will also point out that the term premium cannot be directly measured, rather it is the difference between the long-term rate and the average of expected future short-term rates.

The following chart shows the current shape of the Treasury Yield Curve as of 3/31/23 compared to the beginning of 2022. The current shape of the curve is inverted with shorter term yields higher than long-term yields. At the start of 2022, yields were much lower, but the curve had a typical upward slope.

What is a yield curve inversion?

A yield curve inversion occurs when short-term maturities have higher yields than longer-term maturities.

An inverted yield curve is a sign of a pessimistic economic outlook and typically signals that investors expect the Fed to cut rates soon. Historically, an inversion usually means the market is forecasting an economic recession or slowdown. The inversion typically occurs when there is a “flight to safety” and investors buy longer-term treasuries, which pushes their yields lower than short-term Treasuries. In this scenario, investors expect that economic growth will slow and the Fed will likely cut short-term rates in response; this explains why investors would be willing to accept lower yields for longer maturities. If the Fed does cut rates as investors expect, shorter-term Treasury yields like the 3-Month and 2-Year will then fall below the 10-Year and the yield curve will be upward sloping again.

Which yield spreads are most important? Where do they currently stand?

There are three common spreads associated with yield curve inversions that are utilized as recession indicators. Some investors favor one over the others. At Winthrop Wealth, we watch all three yield spreads equally and they are included in our Recession Dashboard. Currently, all three yield spreads are flashing a recession warning signal.

10-Year Treasury Yield minus the 3-Month Treasury Yield (10YR-3M):
🡆 Current Spread: -134 basis points (-1.34%; a basis point is one hundredth of one percent).
🡆 Signaling a recession.

Implied Yield on 3-Month Treasury in 18 months minus the 3-Month Treasury Yield:
🡆 This is Fed Chair Powell’s preferred yield spread. Chair Powell believes that if the short end of the yield curve is inverted “that means the Fed is going to cut, which means the economy is weak.”
🡆 Current Spread: -122 basis points (-1.22%).
🡆 Signaling a recession.

10-Year Treasury Yield minus the 2-Year Treasury Yield (10YR-2YR):
🡆 Current Spread: -56 basis points (-0.56%).
🡆 Signaling a recession.

The following chart shows the spreads of the 10-Year minus the 3-Month yield in blue and the 10-Year minus the 2-Year yield in grey over the last 30 years. Note that recessions (2001, 2007, and 2020) are shaded in red.

How do the economy and stock market typically perform after an inversion?

We have data on the 10YR-3M and 10YR-2YR spreads going back to the early 1960s. Over the past sixty years, there have been eight instances of a 10YR-3M and 10YR-2YR inversion that preceded a recession. We focused our analysis only on periods where a recession occurred. There have been several instances where a yield curve inversion did not precede a recession (1956 and 1959). There were also periods where the yield curve inverted, went back to positive, and then inverted again before a recession started (1966, 1989, 1998, and 2005). We counted inversions based on monthly Treasury yields since 1962 and recessions based on official National Bureau of Economic Research statistics.

Source: Winthrop Wealth, Bloomberg, and National Bureau of Economic Research (NBER).

A few observations about the data:
🡆 A yield curve inversion before each of the last eight recessions is notable. However, eight is a small sample size.
🡆 Prior to 2019, yield curve inversions occurred without the Fed intervening in the bond market through their quantitative easing program.
➤ While the yield curve did invert in 2019 before the 2020 recession, it is very unclear if the United States and global economy would have experienced a recession without the pandemic.
🡆 There has been a significant lag between an inversion and a recession or market peak.
🡆 The S&P 500 has historically performed very well in the periods between inversion and recession.
🡆 Historical averages would forecast a recession and market peak at some point in late-2023 or early-2024.

Does this mean a recession is imminent?

We started writing that a mild US recession felt inevitable last summer, and our view has not changed as several recessionary indicators are still flashing yellow or red. Over the past several weeks manufacturing data, economic indicators, consumer spending, and the housing market have all weakened. It’s not hard to see signs of a recession in these areas. Meanwhile, the strength of the economy currently lies with the labor market as the unemployment rate of 3.6% is close to a 50-year low. With the Fed actively trying to soften the labor market to bring down inflation by lowering the overall demand for goods and services, we expect the unemployment rate to tick up over the next few months.

An over-simplified business cycle historically followed a similar pattern: the economy expands rapidly – unemployment falls – inflation overheats – financial bubbles form – the Fed responds by raising interest rates – credit tightens – good borrowers struggle to find loans – the economy stumbles – a recession occurs – the economy bottoms – repeat. We’ve seen the first stages of the business cycle play out starting in mid-2020. The turmoil in the banking sector that started with Silicon Valley Bank may end up tightening credit enough to push the economy into a recession. According to the latest FOMC minutes, the Fed now projects “a mild recession starting later this year given the assessment of the potential economic effects of the recent banking-sector developments.” Please see below for our thoughts on why a recession does not necessarily have to be a traumatic event for long-term investors.

United Stated Recessions and S&P 500 Performance

The National Bureau of Economic Research (NBER) Business Cycle Dating Committee is charged with maintaining official records of expansions and recessions in the United States. The NBER defines a recession as a significant decline in economic activity while an expansion is defined as a period where economic activity rises substantially. According to the NBER, since 1929 there have been 15 recessions in the US lasting an average of 13 months each.

The open debate on whether the economy has already fallen into a recession will continue for a while longer. The NBER has stated the current period does not meet their definition of a recession.

The good news for long-term investors is that the S&P 500 already priced in an average recession last year when the index fell by -24.5% from January 3rd through October 12th. We are not sure if October 12th marks the ultimate bottom for this period, although unless your view is that this is the start of another Great Depression or Financial Crisis, then a lot of the damage in the equity market may have already occurred at the recent low.

A key tenant to our investment philosophy is to maintain a long-term viewpoint. A lot of short-term predictions about the market or the economy are just noise. As such, we focus on the fact that recessions can create buying opportunities for long-term investors. During the last 15 recessions, the S&P 500 declined by an average of -30.0%. However, once the market bottomed, performance was very strong over subsequent 1-YR (+50.1%), 3-YR (+79.0%), and 5-YR (+142.1%) periods. We will rely on our time-tested process to utilize any market volatility as an opportunity to tax loss harvest, reposition and rebalance portfolios, and selectively put money to work for clients that have recently made contributions to their accounts.

At Winthrop Wealth, we apply a Total Net Worth Approach to both comprehensive financial planning and investment management. We believe financial planning drives the investment strategy and provides a roadmap to each client’s unique goals and objectives. The comprehensive financial plan defines cash flow needs, is stress tested for various market environments, seeks to optimize account structures, considers tax mitigation strategies, and continuously evaluates financial risks as circumstances and/or goals change. The investment management process is designed to provide well-diversified portfolios constructed with a methodology based on prudent risk management, asset allocation, and security selection. Investors are reminded that no strategy assures success or guarantees against loss.

Source: Winthrop Wealth, Bloomberg, and National Bureau of Economic Research (NBER).