Two months ago, the yield curve ‘inversion’ was one of the most cited data points for recession worries. And for good reason – sustained yield curve inversions have preceded nearly every recession in the post-World War II era. Considering that pockets of U.S. macroeconomic data were showing weakness around the same time as the inversion, the yield curve played perfectly into negative sentiment building around the current economic expansion.
That was summer. Today, the yield curve has turned positive again, after what ultimately amounted to a relatively brief inversion. In the charts below, a yield curve inverts when the blue line falls below zero, which you can see occurred in the summer and early fall months of this year. Today, the yield on the 10-year U.S. Treasury bond is higher than the 3-month and 2-year U.S. Treasury bonds (depending on your preferred measure for the yield curve), creating a slightly positive – but essentially flat – yield curve.
Yield Curve as Measured by 10-Year U.S. Treasury Minus 3-Month US Treasury
Source: Federal Reserve Bank of St. Louis1
Yield Curve as Measured by 10-Year US Treasury Minus 2-Year US Treasury
Source: Federal Reserve Bank of St. Louis2
Now that the yield curve has turned positive again, one would think that the recession narrative would ease up a bit, giving way to more positive readings on economic growth. But that hasn’t been the case – as far as I can tell, the ‘wall of worry’ has gotten even bigger. I would argue this is good news for stocks, for three reasons.
For one, it was not very well disseminated that while yield curve inversions almost always precede recessions, it does not necessarily happen right away. Recessions triggered by the inversion of the yield curve don’t, on average, materialize until 22 months after the event, and during that time, the S&P 500 has tended to rally. In the post-World War II era, on average, the S&P 500 has rallied more than 15% in the 18 months following a yield curve inversion.4
The second reason is that we have not seen anywhere near the deterioration in the labor (jobs) or credit markets that we have seen historically with yield curve inversions. Lending growth at banks remains positive and net interest margins are higher than what the yield curve implies. The rates banks are charging on mortgages, credit cards, and business loans are materially higher than the yields on the 10- and 30-year U.S. Treasury bond.3
Finally, it is important to take note when positive economic developments are largely ignored. When the yield curve inverted over the summer, it grabbed headlines and fueled recession chatter on a near-daily basis. But when the yield curve turned positive – which should have brought relief to the markets that a recession fear faded – it was largely tuned out by most pundits and the press. When pessimism rules the day, expectations are often lowered too far and recession risks get priced-in – giving way for underappreciated economic positives to ultimately drive stock prices higher, in my view.
Bottom Line for Investors
In my view, we’re in an environment where even the slightest bit of negative news adds to the “wall of worry,” but positive news is largely ignored. The yield curve in 2019 offers a perfect example of how this plays out: A yield curve inversion happens over the summer and signals forthcoming recession, followed by the yield curve turning back to the positive a few months later and receiving no air time.
The stock market is ultimately driven by expectations versus reality, in my view, and when expectations are low and falling – but the reality points to economic growth (even if middling) – I think the positive surprises along the way are what lead to higher prices.