Flip Flops Are Not Just For Politicians

Sometimes interest rates do them too!

If you happen to have read the Wall Street Journal the weekend of April 6th, you may have concluded that we are in the middle of a nice smooth rising market “with stocks climbing for the seventh trading session in a row, capping a quiet week of trading.”
 
This article was an interesting contrast to the alarm bells that the Journal was ringing just two weeks earlier. In a radically different tone: “fresh data suggesting the global slowdown…. U.S. manufacturing activity sliding to its lowest level in almost two years

…. the drumbeat of unsettling news Friday drove the yield on 10-year Treasury notes below that of three-month bills for the first time since 2007.”

 … an inverted yield curve has preceded every U.S. recession since 1975 and is viewed as a reliable predictor of downturns.”

So which one is it? Are we heading into a recession, with choppy volatile markets ahead? Or are we poised for continued growth with steadily rising markets ahead?


The inverted yield curve and why it matters:

The “yield curve” refers to the relationship between short term and long-term interest rates. Interest rate risk is the concept that investors lose money in a rising interest rate environment when they have their money locked up for longer periods of time. To compensate investors for taking this risk, longer maturity instruments generally earn higher yields than shorter maturity instruments, hence a normal yield curve has a positive slope to it.

An inverted yield curve happens when investors are no longer concerned about rising interest rates, but are more concerned about falling interest rates and falling asset prices.
 

Yield curve inversions oftentimes happen when the economic cycle shifts from growth to recession.

ACCURACY AT PREDICTING RECESSIONS

How accurate is an inverted yield curve at predicting recessions? After all – “an inverted yield curve has preceded every U.S. recession since 1975!”

We looked at the data from the last ten yield curve inversions here in the United States (excluding the most recent) to see if it was accurate in predicting future recessions. It turns out that there were three false positives and seven accurate predictions. 

Source: Capital IQ, Telos Asset Management Company

Of the ten times that the yield curve inverted over the last 55 years, seven of them were proceeded by a recession, and the average return of the S&P 500 from the one-year anniversary of inversion was 3.2%. The average three-year return from the time of inversion was 5.3% and the average five-year return was 7.3%.

Missing the Mark

Duke University Professor Campbell Harvey has done extensive research on this subject and his general conclusion is that the yield curve needs to remain inverted for three months to have any real predictive accuracy. In other words, a week or two of inversion is more likely random noise than a leading indicator.

Where the financial press may be missing the mark is in their extrapolation of ten points of data. To make sweeping conclusions on such a limited data set seems a little ridiculous.
 
With that being said, we are not implying that an inverted yield curve is something to be ignored. On the contrary, the relevance of an inverted yield curve is in what it tells us about investor sentiment:

Knowing that investors are willing to accept a lower yield to take on more interest rate risk tells us that we may be coming into an environment where investors demand a higher risk premium to put their capital to work.

 
An inverted yield curve is one of a number of data points that can be used to assess where we are in the economic cycle. It may or may not be relevant with regards to its accuracy in predicting a coming recession. The real relevancy of an inverted yield curve is in what it is telling us about investor sentiment.

The yield curve gets inverted when investors fear the future.

When investors fear the future, financial assets are more susceptible to short-term price depreciation, requiring disciplined investors to prepare for heightened levels of volatility.

These are also the environments that can create the setup for opportunistic investing – environments when the odds significantly improve for those who remain disciplined (How Great Investors Use Fear To Their Advantage).