Despite the Federal Reserve’s variable messaging on interest rates (rate hikes were to commence when unemployment hit 6.5%, which happened over a year ago), we do expect them to implement their first interest rate increase in 9 years before the end of the year. As noted before in this column, rate hikes aren’t inherently bad for stocks – in fact, stocks have done quite well historically during rate hike cycles.

What is a negative for stocks, however, is when rate hikes lead to the flattening and potential inversion of the yield curve. The yield curve shows bond yields, for similar types of bonds, with different maturities (over time). If short-term yields are lower than long-term-term yields, the curve is positive (normal). If the opposite is true, the yield curve is negative (inverted). In this case, sluggish economic growth is often expected.
Here’s a statistic that might shock you: every U.S. recession in the past 50 years was preceded by an inverted yield curve, which the Fed may have a role in creating as they raise short-term interest rates to levels above longer-term interest rates. As the Fed enters a “rate hike cycle,” the yield curve will be something investors will want to watch closely.

Inverted Yield Curves Have Led to Recessions

And recessions – almost by definition – lead to bear markets. Take the two most recent bear markets, for example. From July 1999 to July 2000, the Federal Reserve hiked interest rates from 4.76% to 6.5%, which ultimately inverted the yield curve by March of 2000 – precisely the month the bear market began.

A similar outcome took place prior to the Great Recession and accompanying bear market. As concerns over bubbling prices in the housing market surfaced, the Fed (led by Alan Greenspan) began hiking rates in June 2004 and continued notching them higher through July 2006.

The yield curve flattened and, eventually, inverted, and the recession and bear market followed shortly thereafter.

If you look back at the yield curve as an indicator over the last 50 years, you find the same pattern. The yield curve flattens, inverts and an economic slowdown and bear market follow (with the bear market usually starting first). The yield curve inversion usually takes place about 12 months before the start of the recession, but history shows the lead time can range from about 5 to 16 months. As you can see from the chart above, the yield curve is still nicely upward sloping today, so concerns about a recession and/or a bear market are a little ways off, in my view. But, it’s always something to keep a close eye on especially as we near a rate hike cycle.

Why the Yield Curve Matters

It isn’t just a coincidence that flat or inverted yield curves portend economic recessions. Yield curves set the conditions for financial markets. An upward sloping yield curve means banks can borrow money at the short end of the curve (overnight rates set by the Fed) and make loans at the longer end of the curve (rates on 10-year and 30-year Treasuries, or even higher). They pocket the spread as profit and to go towards the cost of doing business. The bigger the spread, the more banks are incentivized to lend – which is good for the economy.

The opposite is true when the yield curve flattens or inverts. Banks lose their incentive to lend money to consumers and small businesses, since it’s less profitable. Constricted loan activity means businesses have less access to capital to finance growth and investment, and consumers have a more difficult time borrowing money for big purchases like cars and homes. Lower spending and investing, obviously, is bad for the economy – especially here in the U.S., where spending makes up a majority of GDP.

Bottom Line for Investors

As you can see from the chart, the yield curve is still nicely positive. The Fed’s overnight rate is still near zero and the 30-year Treasury sits at close to 3% (at this writing). For the yield curve to invert, it would require large and rapid rate hikes by the Fed, the long end of the curve to fall, or some combination of both. I don’t see any of those scenarios playing out in the next year. The Fed is likely to raise interest rates only gradually and the long end of the curve shouldn’t move in one direction, or the other, very rapidly as long as inflation expectations are modest and economic growth remains sturdy.

But, as we push forward in this bull market, and economic expansion, look for the yield curve to show signs of gradually flattening over the next couple of years.

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