In life and in economic cycles, there are key milestones. A key one for the economy was hit August 14, 2019: The 10-year U.S. Treasury yield was less than 2-year U.S. Treasury yield. In other words, the yield curve “inverted.” The inversion that day was brief and slight, as the 2-year yield was barely above the 10-year yield. Yet in a market already pressured from the volatile shifts in U.S. tariff policy, this milestone was not welcome. Financial market volatility spiked and equities declined by almost 3%. Why?
An inversion is a milestone confirming the economy is late in its cycle, with a rising risk of the economy shifting from expansion to contraction. Historically, when the 10-year minus 2-year yield spread turns negative (inverts), a recession has followed. Every recession over the past 40+ years has been preceded by an inverted cycle curve. Important caveats exist, however.
· While each recession has been preceded by an inverted yield curve, not all inversions lead to a recession. An example is 1998, when the spread turned negative briefly for a month before returning to a positive spread and no recession transpired.
· There normally are significant lags between inversion and when a recession starts. As the table below shows, since the late 1970s, on average, the recession has started 16 months after the 10-year and 2-year yields invert:
· While equities usually peak before the beginning of a recession, there normally is a lag between inversion and when the equity market (S&P 500) peaks. As shown below, since the late 1970s, on average, the S&P 500 has peaked 13 months after inversion.
The recent inversion is an important milestone for the economic cycle. But inversions themselves do not cause recessions, and there can be significant lags between when an inversion occurs and markets peak and recessions start.
Obsessing about one milestone does not lead to optimal decisions. Inversions are symptomatic of broader market and economic conditions. So a more thorough perspective is needed. It is important to remember that one of the most significant advantages of a diversified portfolio is that it alleviates the need and/or desire to time the market (e.g., make huge allocation shifts like moving mostly to cash) in anticipation of a potential event that may or may not occur. The OPCM Investment Team integrates fundamental, valuation-focused security analysis, with the monitoring of many economic and financial market indicators, to proactively manage portfolio risk-reward.
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