Tuesday, November 1, 2022
Wednesday last week, the three-month Treasury yield moved above the 10-year Treasury yield, a condition known as yield curve inversion and historically an important warning flag of elevated recession risk. But has it also been a warning flag for market returns? Historically, that depends on the risks that have already been priced into markets.
An inverted yield curve is usually a sign that the Federal Reserve (Fed) is responding aggressively to an overheated economy and/or inflation. Right now, we certainly don’t have an overheated economy, despite a strong labor market, but we are struggling with high inflation.
As shown in the LPL Chart of the Day, yield curve inversion independent of other factors has historically implied tepid forward-looking returns for the S&P 500 Index, giving us just a 2% price return over the next year, on average. But what has happened over the previous year makes a difference.
A positive return in the prior year when the yield curve inverted has historically provided a near flat return in the next. A negative return in the prior year has provided a below-average but respectable 7.3% forward year return, although not without some added volatility in the interim. If you include only the prior year double digit declines (which we had last week), the average historical return over the next year jumps to 13.5%. Granted, that’s only four cases, a very small sample, but it’s what’s most similar to where we are now.
If you look at inversion accompanied by a mid-term election year, the historical numbers look even a little better: 1966, 1974, 1978, 1992, 1998, and 2006 were all mid-term election years, as is this year. The only negative return a year later was an inversion that took place in early 1966 when the calendar effects for mid-term years are still typically negative.
Yield curve inversion implies potential risks ahead that shouldn’t be ignored. It does usually mean continued volatility. But if we do get a recession in the next year, it will be one of the least surprising recessions over the last fifty years, and that may potentially be good for markets.
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