Yield Curve Inversion Perversion
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When I read and hear the various analyses of the market over the past couple of weeks, I’m reminded of a common but timeless joke about two economists talking about a colleague:
Economist 1: He’s one of the best economists in the world Economist 2: What makes you say that? Economist 1: He’s predicted 10 of the past 3 recessions
Economists, and market analysts in general, are notoriously bad at predicting recessions, and notoriously good at self-promotion when they occasionally get it right. Recessions are hard to forecast because often the factors triggering them come out of nowhere, such as a housing credit crisis, an internet bubble, or an oil embargo. Nonetheless, analysts are paid to analyze, and the white whale of market analyses is correctly predicting a recession.
When there appears to be some statistical factor that gives credence to a recession forecast, analysts’ pulse rates heighten with the thought of going on CNBC or Twitter with their evidence. Enter the concept of “yield curve inversion.”
A Quick Primer on Interest Rate Theory
The yield curve is simply a graph of interest rates on bonds and the maturity of those bonds. Most of the time, interest rates increase as the maturity of bonds gets longer. The theory for why this occurs is one of the most common-sense theories in economics – liquidity preference. On average, investor’s demand a higher rate of interest for longer term bonds because they are tying up their money for longer periods of time. For example, on average ten-year Treasury bonds have nearly a 1% higher yield than two-year Treasury bonds since 1976*. Of course, sometimes that difference is higher than 1% (its been as high as 3%) and sometimes it’s lower. A typical yield curve is shown in the graph below:
Yield Curve Inversion
And…sometimes, the difference is negative – the ten-year interest rate is lower than the two-year rate. That is what most market analysts call yield curve inversion. It has happened seven times before this year since 1975. And then, two weeks ago, it happened for the first time in 13 years. Analysts, professional and amateur alike, collectively acted like an asteroid was hurtling towards the earth -- in their view, yield curve inversion meant conclusive proof that a recession is forthcoming.
Let’s look calmly at the data and see what the fuss is all about, exploring and exploding three myths.
Myth 1: A yield curve inversion has preceded every recession in U.S. History.
I heard that quote from several analysts, and one, citing the past nine recessions, on the CBS news website. Technically it’s accurate, but not overly helpful. Here’s another statistic that’s just as relevant. I have broken a bone five times in my life – each of those has preceded a recession. Sometimes the break preceded the recession by several months, and sometimes by several years. Any two events can appear to be related if we don’t define the time period.
Myth 2: A yield curve inversion has preceded every recession by some reasonable amount of time.
This is categorically false. I consider a reasonable amount of time to be one year. After all, if there is some causal link, why would it take longer than a year for a recession to show up? But I’ll be generous and extend the time period to 18 months – approximately the gestation period of an elephant. In that case, the seven yield curve inversions since 1975 have correctly predicted a recession** three times – less than half. That’s far from a compelling statistic.
Myth 3: Yield curve inversions are bad for the stock market.
This is really what most of the analysts who are having conniptions about yield curve inversions are implying, right? As an investor, are you worried about recessions per se, or are you worried about the performance of your stock market portfolio? Obviously, it’s market performance that should be the bigger concern. And yet, I haven’t seen an analysis of stock market performance in the yield curve inversion analyses. Until now.
For perspective, over the past 50 years the average annual return on the stock market has been about 9%.*** During the twelve months following the seven yield curve inversions, the average stock market performance has been 14.2%. If we extend the period to the five years following a yield curve inversion, the average stock market performance has been 10.1%. Both the one-year and five-year performance numbers are above the stock market average over that time period. So, the results are conclusively the opposite of what most articles on yield curve inversion have implied.
None of this is to say that a recession might happen sometime in the future – indeed, we mentioned this possibility in our commentary last month. However, the fact that the yield curve inverted doesn’t lend more weight to the likelihood of a recession.
We don’t actually believe that inverted yield curves are a boost for the stock market – sometimes, data results just happen for spurious reasons. But we have yet to see a compelling theory for inversions being bad for the stock market, and, obviously, there is no empirical support for such a theory.
Financial reporters and analysts have to write about something – it’s their job. In most cases their pablum is innocuous. In this case, the panic they helped precipitate (the stock market fell by 3% on the first day of the inversion) by not thoroughly considering the implications was irresponsible.
* Treasury bond yield data from Federal Reserve Bank of St. Louis
** Recession data from National Bureau of Economic Research
*** Stock market data is for the S&P 500 from Markov Processes International. All calculations are by Savant Investment Group, LLC.