Yield Curve Inversion: Eight Reasons Why I’m Not Worried Yet

Well, there you have it: The Yield Curve inverted last month. Finally! Starting on March 22 and throughout much of last week, short-term interest rates (e.g., the 3 months bills) yielded slightly more than the bond market bellwether, the 10-year Treasury bond.

YieldCurveInversion Chart06
The 10-year yield dropped below the 3-month yield for a few days in March!

People in finance and economics view this with some concern because history has told us that an inverted yield curve is a pretty reliable recession indicator. And I made this point in my post in February 2018: The yield curve shape, especially the slope between longer-term yields (10 years) and the short end (e.g., 2-year yields) is one of my three favorite macro indicators:

Retire at Market Peak Chart01
From last year’s post: Yield Curve slope (10Y vs. 2Y Treasury bonds) over time. A powerful recession early warning signal (1970-2018)!

Also notice that I usually look at the 10-year vs. 2-year yield rather than 3-month spread and that made a bit of a difference recently, more on a little bit that later. But in any case, since I went on the record about the importance of the yield curve and now got several reader requests to comment on this issue, here’s an update: in a nutshell, I’m not yet worried and here are eight reasons why…

1: The 10-2 yield spread never inverted

Keep in mind that in the post last year I had used the spread between the 10-year and 2-year Treasury yields. That spread never went below zero (at least up until 4/2/2019 when finalizing this post). Am I just cherry-picking here? Imagine back in 2018 I had proposed using the 10y-3m spread (the one that recently inverted) and now I said: “oh, don’t pay attention to what I said last year, because the 10-2 spread is still positive!” Well, that would look like shifting the goalpost. But I’m consistent here: the 10-2 is what I proposed back then and that’s what I still look at. In the past, the 10-2 had been a more timely and consistent indicator than the 10y-3m spread and, therefore, I’ve always preferred the 10-2 version of the yield spread.  There are a few more reasons that would all justify their own separate blog post – remember I used to do economics and finance for a living – but I don’t want to bore you with too much econ-babble. 🙂 All I want to stress here is that despite the big hubbub in the media last month, I’m not that worried until the 10/2 spread inverts!

YieldCurveInversion Chart07
The 10-year yield never dropped below the 2-year yield!

2: The Yield Curve “un-inverted” again this week

Well, the whole episode didn’t last too long. The 10-year yield dipped below the 3-month yield for a few days between March 22 to March 28 but jumped up again after that. What do I make of that? Again, together with the fact that the 10/2 spread didn’t even invert, I’d not consider the event last week a full-blown significant macro signal.

Of course, critics would argue that in most previous events, the yield curve “un-inverted” again before the start of the recession, see the time-series chart above in the intro. To which I’d respond that not just was the duration of the yield curve inversion quite short but also the intensity was much lower than in the previous events, which brings us to the next point:

3: The 10y-3m and 10y-1y yield spreads only barely dipped below zero

Not only did the two spreads revert again but they never even fell far below the zero line. That’s in stark contrast to prior events, see the table below. In every prior yield curve event that preceded a recession, the short-end yield not just touched and slightly passed the 10-year yield but the magnitude of the yield curve inversion was much more significant than in 2019!

YieldCurveInversion Table02
The minimum (most negative) slope of the 10-year vs. shorter-term yields in the last seven yield curve inversions: The magnitude of the most recent yield curve inversion is much more benign than in most of the previous events. Source: Federal Reserve

Well, the one occasion where we saw only a very shallow inversion was in 1998. But do you notice something? That was the one yield curve inversion that wasn’t immediately followed by a recession. Which brings us to the next point…

4: There’s been one “false alarm” that looks strikingly similar to the March 2019 Yield Curve inversion!

Every recession in recent history was preceded by a yield curve inversion. But in and of itself, that’s not all that impressive. Every recession in the past has been preceded by a Wednesday. That doesn’t mean that every Wednesday we’ll have a recession. A good macro indicator should (almost) never miss an actual event (type 2 error) but it shouldn’t have too many false alarms (false positive, type 1 errors) either; think of Paul Samuelson’s famous quote “The Stock Market Has Predicted Nine Of The Past Five Recessions.”

The yield curve signal did produce one false alarm in 1998. In other words, the curve inverted back then but that was way too early! There wasn’t a recession for about 3 years after the 1998 event. Rather, the yield curve normalized again before it eventually inverted in early 2000 (and with a vengeance, see the chart below!), about a year before the March 2001 business cycle peak.

YieldCurveInversion Chart03
Prior to the March 2001 recession start, there were two yield curve inversions: A brief and shallow event in 1998 (false alarm) and one long and sharp inversion in early 2000.

Actually, the 1998 event is a bit reminiscent of the one in March this year: A very short and shallow yield curve inversion. And in 2019, the 10y-2y slope didn’t even invert! We can’t know for sure how the future will turn out. Maybe we will face the first big recession with only a very mild curve inversion. But I wouldn’t assign a very high probability to that!

5: Even if this yield curve inversion signals an upcoming recession it could still be years(!!!) away

There isn’t too much comfort in this one but I should still point out the obvious. In the past, the yield curve inversion would sometimes occur way before the start of a recession, see the table below. About nine to ten months at the minimum and most often more than a year in advance (not even mentioning the 1,040 days or almost three years of the 1998 false alarm).

YieldCurveInversion Table01
Number of calendar days after the Yield Curve Inversion until the start of the recession. The beginning of the recession can be years away! Source: Federal Reserve, NBER.org, ERN calculations.

Well, maybe the performance of the economy is not on your mind all the time. But I’m sure the stock market is, right?! Which brings me to the next issue…

6: In past instances of yield curve inversions, equities didn’t even perform that badly in the near-term

This is obviously related to the point above, but it’s important enough stress it again. Not only is the recession potentially a long time away, but so might the equity market peak! In other words, even if you take the yield curve inversion seriously, it’s not exactly an equity-sell signal. There have been instances in the past where the inversion occurred when the bull market was still very much intact, with months and even years, to run. Below is a table with a chart with the S&P500 index performance (nominal dollars, dividends reinvested) after the 10y-3m spread went negative. There was only one precedent where you lost money over the next year! Not exactly an urgent sell signal!

YieldCurveInversion Chart01
In 4 out of the last 6 instances of the 10y-3m Yield Curve Inversion, the S&P had 12+ more months of great returns!

Thus, even if we take this yield curve inversion really seriously (and I still have some serious doubts!), right now I’d be on alert rather than panicked. This is not the time to run for the hills and sell stocks!

7: The Federal Reserve isn’t as aggressive as in the previous tightening cycles

A lot of the previous recessions coincided with the Federal Reserve raising short-term interest rates aggressively. It always goes like this: The Fed tries to fight inflation (perceived or actual) by raising interest rates to cool down the economy. The short end of the yield curve goes up but in expectation of the inevitable economic slowdown, longer-term interest rates already price in the prospect of a future recession and lower rates. The Fed will eventually go overboard with rate hikes and sink the economy. And right before that the yield curve inverted.

The current tightening cycle seems very different, though. Rate hikes started from a very low level, the rate hikes were very gradual and the final resting point (a 2.25%-2.50% range as of today) is much lower than in prior events. In fact, today’s (tentative) endpoint of the rate hikes is lower the lowest rate during the entire 1990s, which stood at 3.00%!

YieldCurveInversion Chart02
When raising interest, the “Fed” used to be a lot more aggressive in the past (and don’t even get me started on Paul Volcker in the early 1980s!). The gradual rate hikes over the last 3+ years pose a lower risk of overshooting on rates and choking off the economy!

8: Other macro indicators still look quite solid

In the original post last year I mentioned that the yield curve signal is only one single indicator. Nobody in their right mind would propose forecasting an economic slowdown with just one single indicator. In my professional life before FIRE, I used to monitor hundreds, even close to a thousand global economic and financial indicators. No worries, I found a way to automate this and let the computer do all the work for me to sort out the noise vs. signal, thanks to some innovative methods I developed. But you know what, the Pareto Principle works too: 80% of the outcome is due to 20% of the effort. In this case, it may even be that 0.3% of the effort, i.e., checking 3 indicators out a thousand gives you almost everything you need to know.

In any case, the other two macro indicators I like to follow all look really good until now. Let’s take a look…

8.1: ISM-PMI Index

The ISM-PMI indicator stood at 55.3 as of 3/31/2019 (data released on 4/1/2019). That’s still a very solid reading: 50+ means expansion and even a tempdrop below 50 is common during economic expansions. I’d be on alert (not yet panicked) if the PMI drops below 50 and I’d be pretty panicked only if the PMI drops below 45. We’re still far away from that!

YieldCurveInversion Chart05
ISM-PMI Index (Manufacturing Purchasing Managers Index). Still above 55 as of 3/31/2019, not exactly screaming “slowdown” yet!

8.2: Unemployment Claims

Nothing new here either. There was a small bounce in late 2018/early 2019, likely related to the government shutdown but we’d need to see a much larger move. Remember, unemployment claims are still very close to multi-decade lows! This doesn’t look like a bona fide macroeconomic slowdown! Quite the opposite, the labor market is still rocking!

YieldCurveInversion Chart04
The weekly unemployment claims (here the 4-week moving average) are close to multi-decade lows. We’d look for a marked deterioration (i.e. rise) in this number around a recession.

So, strictly speaking, out of my 3 indicators, none of them indicate a slowdown yet if I use the 10/2 yield spread rather than the 10y-3m spread! Nothing to see here folks, let’s move on, there doesn’t seem to be a recession around the corner!

There you have it, my views on the yield curve inversion! Hope you enjoyed today’s post and please leave your feedback below!

Advertisements

46 thoughts on “Yield Curve Inversion: Eight Reasons Why I’m Not Worried Yet

  1. Great post, Big ERN. Great to read some calming points about the economy/markets when other sources are warning of a recession at our door step. Your analysis is more in line with what I see. Employers all over are scarmbling for new hires and markets are bouncing back from the 2018 correction in a big way. Bull markets don’t run forever but this one still has legs, in my humble opinion.

  2. As always, fantastic post, Big ERN. I have been eagerly waiting your analysis on this. Thanks so much!

  3. Good post. I still don’t try to time the market myself but it’s still nice to read some decent info instead of panic, click inducing news links.

    1. Very good point! Sometimes it’s best to monitor what’s going on in the macro world to justify not reacting and staying passive. That’s what I try to do here: look for justifications to sell equities and realize that this high burden is not met right now! Despite the BS I read in the news about this YC inversion. 🙂

    2. 1) I read today’s low unemployment numbers as a recession predictor. In US economic history, how long has the country been able to sustain sub-4% unemployment rates? At some point, a lack of workers (and undeserved desperation promotions) puts an end to growth.

      2) Note: The 1998 episode coincided with the Asian financial crisis, which threatened to become what the 2007-2008 financial crisis eventually became. It was a bumpy ride, but stocks ended the year way up.

      https://www.pbs.org/wgbh/pages/frontline/shows/crash/etc/cron.html

      In today’s case the inversion was not triggered by any particular crisis. The closest trigger event might be tariff negotiations with China, but they were are reportedly going well. The lack of imminent crisis as a cause of the inversion is problematic if we are to declare this another 1998.

      3) I’ve heard stocks usually fall 6 months prior to a recession. If the inversion signal

      4) Would it be possible for a very large fund to manipulate the treasuries market in order to create this unusual yield inversion and prifit from a decline in stocks? (i.e. unusual in that wouldn’t inversion of the 10/2 be more likely than what we’ve seen?) Might the trading volumes allow for such a fraud?

      1. All good points.
        1: I don’t think that the expansion needs to end just we get to <4% unemployment. So far inflation has stayed subdued and even if there's a little bit of inflation above the 2% target there are several FOMC members that seem to be OK with it.
        2: So, that's additional justification not to worry. I think the current YC inversion was even more of a fluke than in 1998.
        3: In 2007 it was 2-3 months before. Equity peak in early-mid October and recession start in December. Since the YC inversion often happens 12+ months ahead of the recession there is normally still some time for equities to run.
        4: No. It's a big market. If you add futures plus physicals you're in 100s of billions of dollars in trading volume EVERY DAY. But I think that a foreign government with enough Treasury holdings could theoretically "manipulate" the market.

    1. Well, to some degree the post is spot on. Recall that this is the exact same series that I use as my top labor market indicator and one of the three top macro indicators! But there are some flaws to their exact rule:
      There were a lot more false signals to their exact crossover rule, e.g. too early in 2007 even though they never marked that spot in their chart, 1995, etc.
      This signal will also give a false positive if the claims were to stay low and bounce around for the next 5 years even if there’s no recession.
      The message here is that there can never be a purely strict and mechanical rule. It takes a little bit of science and art (!!!) to see when the claims are taking off and it’s time for the next recesssion.
      But thanks for the link!!! 🙂

  4. Great analysis Karsten. Corrections are actually frequent (about once per year since 1900) and in 80% of cases, they do not turn into a bear market (20% drop). Bear markets have actually happened every three years or so since 1900. So yes, bear markets and recessions happen. It’s part of life. Will the next one be in 2020? 2021? Don’t fear the future. Have a reasonable SWR (I like a CAPE-based formula) and be flexible if needed to minimize SoRR.

    1. Yeah, a bear market will happen again. But it’s still exciting to monitor the macroeconomy because the bear markets that are damaging from a SoRR point of view are those that coincide with recessions, especially the really bad ones (1930s, 1970s, 2007/8).
      But you’re totally right about the frequency of sharp drawdowns! 🙂

  5. Hi Big ERN, do you have an opinion on the all-weather portfolio described by Ray Dalio? If you use his diversification strategy we may not need to worry about predicting when there will be a recession or sequence of returns risk.

    1. Depends.
      If I assign my personal expected real returns:
      Equities: 5%
      LT Bonds: 0.8%
      Interm Bonds 0.4%
      Gold: 0.5%
      Commodities: 0%
      Then that’s a weighted real expected return of 2%. Depending on your age and stage in life this might be appropriate or not at all appropriate:
      1) you’re young and still accumulating assets. This portfolio sucks. You should take much more risk (and get higher expected returns) and not worry about flucuations. See my post from January: “How can a drop in the stock market possibly be good for investors?” https://earlyretirementnow.com/2019/01/23/crash-good-for-investors/
      2) You are early retired: You are planning a 4% real withdrawal rate and you generate only 2% on average. That will not last very long (expect your money to run out after 35-40 years). Or keep this short-term and then do a glide-path to a higher risk and return portfolio.
      3) you are retired and 65 years old. This might actually work very well! Because over a 25-30y retirement horizon you only need to generate 1-1.3% average real return and use cptial depletion for the rest to make the 4% rule work.

      1. What if you juice this up with some leverage? Is that what all-weather does? I guess I should read (and think) more first, comment later…

        1. Good suggestion! That would do the trick! The nice thing is that the all-weather portfolio is close to the tangency portfolio, which has the highest risk-adjusted expected return. But in absolute numbers the exp. return would be too low. If you scale this up by maybe 2x, now we’re getting somewhere.
          It’s not trivial to do for the average Joe investor, though. You’d need to trade futures to do that. Or use leveraged ETFs but they have high expense ratios.

      2. ERN, I noticed your “personal expected real returns” don’t quite match what’s in the SWR Toolbox 2.0 spreadsheet. Have you laid out your thinking behind these figures anywhere? I’m especially curious of the thought process that leads to gold having a 0.5% (or 1%, in the Toolbox) real return 🙂

        As always, thanks for the article! Brings some perspective to all those mainstream media articles playing up the 3M-10Y inversion when, as you pointed out, they’re not even looking at the most historically accurate ratio…

        1. Yeah, I don’t update those “expected return” in the SWR sheet regularly.
          Gold had a 1% real return over the very long-term (100+ years) but I would shrink that toward zero (half-way) to account for theuncertainty and potential ETF expense ratios (0.4% for GLD).

          Of course, bond expected returns also bounce around a lot. So, if you use the sheet, please use your own numbers you think make sense! 🙂

  6. Big Ern, thank goodness you are back in action, and not a moment too soon! I have been waiting to see what you would say about the inversion. Like you, I have been watching several other indicators and am not too concerned about the economy. However, I have been a bit concerned that there seems to be so much more general awareness of and public chatter about yield curve inversions now than there used to be. It’s making me wonder if there could ultimately be a “self-fulfilling prophecy” effect of people cutting spending and pulling out of the market because they expect a market drop/recession, thus actually leading to the market drop/recession that people expect! If the yield curve were to invert again and stay inverted for longer, would you be worried about that potential self-fulfilling prophecy, or would you just keep your eye on the other indicators and not concern yourself with increasing public paranoia about the yield curve?

    1. Good point! I think after the WSJ wrote today “The World Seems to Have Dodged Recession, for Now” (https://www.wsj.com/articles/the-world-seems-to-have-dodged-recession-for-now-11554489489?mod=searchresults&page=1&pos=1) we probably didn’t do too much damage in people’s perceptions with this very short YC inversion.
      But I could see that “animal spirits” or “self-fulfilling prophecy” issue where everybody (consumers, investors and businesses) hunker down because we all expect a recession and then it actually comes.
      So, yes, if the YC really inverts and stays inverted and there’s some other macroeconomic supporting evidence then I’d be worried. Which is, incidentally, exactly the plan I outlined in the Feb 2018 post.

  7. Great work!
    What strikes me is that there will always be Cassandras who warn that the end if nigh.
    I’m prone to believing that the next collapse is just around the corner and that I alone the insight and expertise to detect – BUT I DON’T.

    Over the years I’ve had to drop interest in certain things due to not having enough time – sports, the arts (mostly), politics back home. maybe it’s time to put the economy on that list (alongside Brexit). talking about things isn’t going to change them and I’m probably not a great investor anyway – so doing the exact opposite of what my gut tells me is maybe the right move.

  8. The use of a more comprehensive and quantitative measure of economic trend, versus singular data series such as the yield curve, may be had through the use of the Conference Board Leading Economic index.
    In the book “A Guide to Modern Quantitative Tactical Asset Allocation” *, A “trend change” in the CB LEI has shown enough precision and statistical confidence for use towards signaling infrequent tactical shifts from equity based assets into safe duration assets in avoidance of significant decline events and sequence of returns risk. The CB LEI is constructed with a composite of 10 data series components ( of which the yield spread being one ), creating a more robust view of economic activity. One may see many of these components being used in analysis and market commentary, in isolated fashion, in attempts to devine the direction of the economy / equity markets.
    A simple combination of the trend change in the CB LEI variable confirmed by signaling produced from a stock market trend identifier ( S&P500 price / moving average variable – core concepts # 3 & 4, chapters 1, 3 & 4 * ), has identified the bulk of significant market decline periods over the past 50 years.

    A key premise to successful investing involves the holding of equity based assets for longest optimal periods ( years in most cases ), and in rare circumstances, temporarily switch to duration assets ( months in most cases ).

    At present, the two trends are positive ( since July of 2009 ) **

    Additionally, from the past historical signals generated ( Chapter 5, Part 1, table 2 * ) in the past, we can see the gains accrued from the onset of the inversion to the next negative trend change of the LEI / moving average variables https://imgur.com/EGpcnQC
    So the clock “may be” ticking towards a defensive signal, but second guessing is futile
    . . . .
    * https://tinyurl.com/y6w4ca8b
    ** https://tinyurl.com/y9rrzral

  9. To me a flat yield curve is not really an indicator is recession here but a simple function of a Fed tightening cycle. The front-end has had to move up over 200bp due to Fed tightening; the 5y5y rate, however, hardly moves given limited changes in both long-term real growth or inflation expectations. Hence by simple mathematical construction you get a fairly chronic flattening in the spot 3m10y curve. Globally we see most developed market yield curves much flatter that history would suggest due to a variety of reasons. The view that we are in a “secular stagnation” environment, demographic changes creating greater demand for safe assets, regulatory changes etc.

    If you look the yield curve in forward space, the inversion is in the front-end between 3m LIBOR and mid 2021. There is about 40bp or so of cuts priced. After that the curve is flat to modestly postively sloped. The market is seeing the balance of risks towards cuts over the next few years. What the forward curve is not pricing is a fundamental Fed policy error (so we are not seeing 1y1y vs. 5y5y inverting). Yes, 2y10y is close to flat but 2y10y, 1y forward is +30-40bp.

    1. All good points. One word of caution about this statement:
      “To me a flat yield curve is not really an indicator is recession here but a simple function of a Fed tightening cycle.”

      There is no either/or. Many past recessions have been caused by Fed tightening cycles. But I agree with your final conclusion that we’re don’t really have to worry yet! 🙂

  10. Greetings from the UK again. So once again great analysis as ever! But let me ask you a question following up on some of my previous posts about the psychology of early retirement.

    Your title says “Why I am not worried yet”…..But why should you be worried anyway? In fact why should you be worried if there is (a) a great depression (b) a long slow decline in equities as was experienced in the 1970’s (c) a very significant financial crisis as was experienced in 2008 or (d) anything else that has been experienced in the years that your safe withdrawal analysis covers.

    I say this because significant recessions, depressions, conflicts and the like will almost certainly occur. And given your SWR is low enough that your portfolio with withstand such events, based on historical returns you should have nothing to worry about.

    What I think one, who is utilising a SWR, should be worried about is known unknowns and unknown unknowns to borrow a phrase from one of your recent politicians. i.e. portfolio returns are materially less than the US has historically achieved (a known unknown), BREXIT (in the UK was a unknown unknown in the first part of this decade to which the outcome now is not known or frankly predictable).

    This is not a dig at all, it’s more of me trying to understand how I will deal with approaching FIRE. I have a largish portfolio and large expenses and query if I would sit there year after year.

    I suspect most people reading and writing on these blogs will waver if there is a serious stock market crash or worse a repeat of the 1970’s.

    Increasingly I am thinking the best answer for me is to carry on some part time work and achieve a better work life balance!

    1. That’s a very valid point. If you pick a SWR low enough you SHOULD prevail. But there are still some nagging doubts, right? In the past, your portfolio would have dropped precipitously (maybe 40 or even 50%) and it always recovered. But you won’t know the next time around. It’s a bit like driving in an armored car: You will still be worried about IEDs.

  11. Make lemonade out of lemons.

    Take the opportunity with a yield curve inversion to re-finance any existing mortgage debt you have. Mortgage rates are based off of the 10-year bond yield. The lower the 10-year, the lower the mortgage rate. When the 10-year fell in late March, it was a great time to lock in cheap mortgage financing.

  12. Hi Big Ern, yet another great article! I have a (hopefully) quick question for you: If you knew someone in their late 30’s that just received a windfall (say $2 million) and wanted to retire early sometime in the next year what would you advise them to invest in and when? Would you advise them to wait until the CAPE was lower? Are there any indicators that you might wait for before investing? Thanks for all of your great insights.

  13. As always, thank you for the education. I like how you filtered it down to 3 indicators, really helps us mortals out when determining asset allocations.

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.