From everyone at LPL Research, we first want to offer our thoughts to former President George H.W. Bush’s family. Most of his life was lived in service to the United States, and he will be greatly missed.
Turning to markets, the spread between both 3- and 5-year and 2- and 5-year Treasury yields turned negative earlier this week for the first time since July 2007. This indicates that the short end of the yield curve has inverted, which has many wondering if a recession will soon follow. Some of yesterday’s equity market drop was also attributed to continuing flattening yield curves.
To clarify, a yield curve is a graphical representation of the yields of bonds with similar credit quality across a range of maturities. A flattening curve, when shorter-term rates rise more quickly than longer-term rates (or fall more slowly), is often perceived as an indication that slower economic growth lies ahead. An inverted yield curve, where short-term rates are higher than long-term rates, has historically been a precursor to a recession. However, in terms of their predictive power, not all spreads are equal.
Inversions at the short end of the yield curve, like we’re seeing now, have had very little consistent predictive power for future recessions. The longer end of the yield curve has historically had the best predictive power. In fact, according to data from the San Francisco Federal Reserve Bank, the 1-year and 10-year Treasury yield spread inverted prior to all nine recessions going back 60 years.
Another more common measure of yield curve steepness, the 2- and 10-year Treasury yield spread, dropped to 0.11% this week—its lowest level since July 2007. Here’s the catch: The yield curve isn’t inverted, and we’ve seen periods with a relatively flat yield curve that have lasted for years before a recession (the mid-to-late 1990s, for instance). With strong corporate profits, high confidence levels, a more accommodative Federal Reserve, and the benefits from fiscal policy still being felt, we do not anticipate a recession over the next 12–18 months.
But what happens if the more predictive yield curve finally invert? As our LPL Chart of the Day shows, equities can continue moving higher even after the yield curve inverts. LPL Research Senior Market Strategist Ryan Detrick explains: “Contrary to what many people think, inverted yield curves don’t always sound the alarm to sell. In fact, looking at the past five recessions, the S&P 500 didn’t peak for more than 19 months, on average, after the yield curve inverted, along the way adding more than 22% on average at the peak.”
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