Don’t Sweat the Inversion Diversion!
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Here’s a sample from a CNBC article just this week:
“5-Year and 30-Year Treasury Yields Invert for the First Time since 2006, Fueling Recession Fears.”
The “fear factor” of impending doom due to an inverted yield curve has been so thick in the financial media lately that you can cut it with a knife.
This story goes on to report that the yield on the five-year Treasury note rose to 2.6361% earlier this week, while the 30-year Treasury yield dropped to 2.6004%. But this brief inversion has since reversed.
It’s the first time since 2006 that a curve inversion of this type has happened, but don’t hit the panic button just yet.
The truth is, all this talk about inversion is just a diversion from what’s more important.
In plain English, an inverted yield curve happens when short-term Treasury interest rates (such as the five-year) move higher in yield than a longer-dated Treasury (like the 30-year). In this case, this is called a 5s/30s inversion (as the lingo goes). The “s” in 5s/30s inversion means the spread between five-year and 30-year Treasuries.
It’s true that in the past, yield curve inversions have spelled trouble ahead for the economy and, by extension, for the stock market.
But it’s also worth noting that back in 2006 when the 5s/30s inverted, stocks continued to rise for nearly two years before the peak. And if you bailed out of the market at the first inversion, you missed out on sizeable gains.
It’s also important to understand there isn’t just one all-seeing yield curve to watch; there are actually dozens of them.
Analysts at Sentimentrader.com track no less than 55 various yield curves that cover different combinations of Treasury market yields from 11 different maturities that range from one month to 30 years.
And the reality is that most of these yield curves are well-behaved right now and nowhere near inverting. The inversion occurs when the blue line drops below the zero line.
The chart above plots the average of these 55 yield curves, and as you can see, it’s currently nowhere near the zero line. In fact, less than 10% of all the yield curves they track are inverted right now. In other words, 90% of the yield curve evidence points to no recession ahead.
However, you can also see that when the average yield curve spread does invert, it has correctly forecast every recession of the last 60 years. That’s why I’m keeping an eye on this broad-based indicator.
But we aren’t there yet. In fact, we’re nowhere close to a broader yield curve inversion. The current yield curve reading is in the top 29% of all readings since 1962, according to Sentimentrader.com.
Plus, when the average yield curve has been at the same level it is right now, stocks have returned an above-average 13.2% per year historically.
But they don’t call economics the “dismal science” for nothing.
And one of the favorite yield curves for the dismal elite to obsess over is the so called 2s/10s spread. That is simply the difference in yield between two-year and 10-year Treasuries.
Back when I started in this business in the 1980s, the yield curve du jour was the three-month versus 30-year Treasury spread. That’s what I learned to watch like a hawk.
But today, the 2s/10s is apparently all the rage, and it has a good track record.
An inversion of the 2s/10s spread has accurately “called” 10 out of the last 13 recessions going back to the 1940s. This is a pretty good forecasting record, but it’s not perfect.
There was a curve inversion in 1965 that was not followed by a recession. Plus, the 2s/10s yield curve did not invert ahead of three recessions between the mid-1940s and early ’50s.
The truth is, a curve inversion is more of an early warning indicator than a signal of imminent doom for the economy.
On average, it has taken 14 months after the 2s/10s yield curve first inverts for a recession to finally hit the economy, according to BofA Global Research. And that’s a long lead time.
The lead time is somewhat less for predicting a stock market downturn, but it’s still not an immediate cause for alarm.
Historically, there have been an average of 7.1 months after a curve inversion before stocks top. And the S&P 500 Index posted median gains of 12% during that interval, which is better than average.
Plus, after a curve inversion, stocks do typically dip, but the S&P can go on to rally in a big way prior to a larger market decline.
In fact, after an initial average pullback of just 4.9%, stocks have historically enjoyed another last-chance rally, averaging 16.8% over the next 6.5 months prior to the final market peak.
The bottom line is that a yield curve inversion isn’t exactly the economic death knell that the media makes it out to be.
It is potentially a sign of trouble ahead for the economy and stock market, but it’s typically many months (if not years) off in the future before the real trouble starts.
It certainly is something I’m keeping an eye on. But I’m not letting yield curve diversions by the media distract me from watching the proven stock market timing indicators we use at TradeSmith. And you should do likewise. Our tools have a tested and proven record of detecting trouble ahead, and they’re worth their weight in gold.