Don't sweat the yield-curve inversion
While respectful of the potential recession signals coming from the past week’s inversion of the shortest portions of the Treasury yield curve (yields at the 1- to 6-months end were higher than the 10-year), Federated is encouraging investors to exercise restraint and patience for three key reasons:
- First, the length and depth of inversion matter—brief and shallow inversions can be false positive signals, such as the one in 1998 that did not lead to recession, whereas deep and sustained inversions have invariably led to economic downturns. As of this morning, several sections at the front of the Treasury yield curve that inverted late last week appear to be re-approaching positive territory. It is also worth noting the inversion arguably had more to do with global central bank quantitative easing/tapering artificially driving down/holding down long yields than it did with short yields moving up, increasing the likelihood of a false positive signal from this yield-curve inversion.
- Secondly, we look at six indicators for signs of potential recession: unemployment insurance claims, housing starts, the yield spread between corporate bonds and comparable-maturity U.S. Treasury bonds, the Institute of Supply Management’s monthly gauge of manufacturing, inflation and the yield curve. Of those indicators, only the yield curve is flashing yellow—even with this morning’s weak and below-consensus February housing starts number, none of the other measures are near recessionary territory.
- Finally, even if the past week’s yield-curve inversion is signaling recession, it’s likely going to be awhile. The lead time between a recession signal and outright recession tends to run one to two years, consistent with our view that the most likely time frame for the next recession is sometime in 2021. History shows that between the time of the initial (and sustained) yield-curve recession signal and outright recession, stocks typically rise significantly. In fact, the last yield-curve inversion to send a true recession signal (December 2005) saw the S&P 500 subsequently climb an additional 22% before the recession hit two years later.