The U.S. economy has experienced 2 recessions in the last 2 decades. The latter one in 2008 & 2009 is considered to be the worst recession since the Great Depression and was dubbed the Great Recession. Shortly before each of these recessions, the interest rate yield curve inverted. In this post we will look more closely at the correlation between an inverted yield curve and the onset of a recession.
After the 2017 rally extended into January of 2018, investors seemed poised to have a second year of stellar returns. The S&P500 surged 7.5% in the first month of the year. Markets were riding high on the euphoria of the new GOP tax cut combined with indications of improved corporate earnings. Then came February with increased fears of a hawkish Fed and the possibility of 4 rate hikes in 2018 to combat rising inflation. In March, these fears were compounded by tariff talks and the US appeared to be on track for an all-out trade war. Despite the resulting 10% correction from the January highs, the good news is that the market is still trading within its trend-lines, as shown in the chart below:
In March, the Fed passed the first 0.25% rate hike and narrowly projected just 3 rate hikes for 2018. Along with rising interest rates comes the fear of inverting the yield curve if short-term rates rise too quickly. The yield curve becomes inverted when short-term rates are higher than long-term rates. Banks typically borrow based upon short-term rates and lend based upon long-term rates. As long as there is a positive slope to the yield curve, the banks can make a profit. When the yield curve flattens or goes negative (inverted), lending tightens. This is bad for an economic expansion since corporations typically need to raise capital in order to grow. For this reason, an inverted yield curve is a common predictor of a recession.
So what are the measures that define an inverted yield curve? One simple indicator is to measure spread between the 2-year and 10-year treasury rates. The chart below shows the S&P500 price performance relative to the spread between the 2-yr and 10-yr rates:
Please note that the S&P500 pricing is plotted on a logarithmic scale. Readers will see that in 2000 the market topped approximately 6 months after the yield curve inverted. This happened again in 2007 when the market topped approximately 16 months after the yield curve inverted. Readers will also note that we are currently 82% of the way back to a flat yield curve since the spread reached a high of 2.81% in February of 2011. If the current rate of decay continues, the yield curve will invert sometime in 2019.
Another approach is to look at the entire yield curve and the average interval between the various duration treasury rates. Specifically, we can look at the average spread between the following rates:
The chart below shows the S&P500 price performance relative to the average spread between these rates:
Again, the S&P500 pricing is plotted on a logarithmic scale. In 2000, the market topped approximately 2 months after the yield curve inverted. Then in 2007 the market topped approximately 12 months after the yield curve inverted. Using this metric, we are currently 71% of the way to a flat yield curve since the average interval rate reached a high of 0.65% in February of 2011. If the current rate of decay continues, the yield curve will invert sometime in 2022 or 2023.
As one might expect, the general results are similar for both approaches. The main difference is that the 10-year to 2-year spread appears to invert approximately 4 months little earlier than the average interval rate approach.
With interest rates on the rise, be watchful of the yield curve as we head into 2019. If the curve inverts, we could see a recession within 2 to 6 months.