On Friday, the 2-year Treasury yield was higher than the 10-year yield, and the much-watched yield curve indicator inverted and temporarily triggered a recession warning after a brief inversion earlier this week.
On Friday, the 10-year Treasury yield rose about 6 basis points to nearly 2.386 percent, while the 2-year yield rose more than 12 basis points to 2.436 percent.
Not a good timing tool
How worried should stock market investors be?
Maybe not very worried now — at least not because of curves. First, economists say that a constant curve inversion is needed to send a strong signal. Even so, the data shows that when the yield curve inverts, it didn't pay a price in the past for abandoning stocks.
While an inverted yield curve is a good indicator of future economic woes, an inversion of the yield curve is not a good timing tool for equity investors.
See: A key part of the U.S. Treasury yield curve has finally reversed, triggering recession warnings — something investors need to know
For example, investors who sold when the yield curve first inverted on December 14, 1988, missed the subsequent 34% increase in the S&P 500. Those who sold off when it happened again on May 26, 1998 missed out on 39% of the market upside. In fact, the S&P 500 has a median return of 19% from the date of each cycle in which the yield curve inverts to the market peak.
Investors didn't seem to be too upset about the curve this week. U.S. stocks closed with strong gains after a brief correction in U.S. stocks on Tuesday. Stock indexes are heading toward losses this week, but the curve hasn't gotten much blame, if any. The S&P 500 will fall 0.5% per week, while the Dow Jones Industrial Average is down 0.7% and the NASDAQ Composite maintains a 0.1% gain.
Inverted and its meaning
Typically, the yield curve slopes upwards based on the time value of a currency. The inversion of the curve suggests that investors expect long-term interest rates to remain below recent rates, a phenomenon widely seen as a signal of a potential recession.
But there is also a lag there. Data dating back to 1965 shows that the median length of time between an inversion and a recession is 18 months, matching the median time period between the start of the inversion and the peak of the S&P 500 index.
Stop the panic about an inverted yield curve – the likelihood of a recession remains low
Which curve?
Since 1978, inversions to the yield curve's 2-year and 10-year indicators have preceded all six recessions, with only one false positive.
Researchers at the San Francisco Fed noted that the 3-month/10-year spread is considered more reliable, even if only slightly more reliable, and more popular in academia. The researchers note that the measure of the curve is still "putting the cart before the horse." In fact, the 10-year yield is nearly 1.9 percentage points higher than the 3-month yield.
Some economists argue that the Fed's bond-buying program artificially depresses long-term yields and distorts signals from the yield curve.
Fed Chairman Jerome Powell said earlier this month that he would prefer a shorter-term approach to measure rates for 3 months rather than expectations for 3 months over the next 18 months.
Two curves diverge
In fact, the divergence between the two closely watched curve indicators has been plaguing some market watchers.
It's worth noting that the two went hand in hand until around December 2021, when March/10 began to steepen with the collapse of 2 and 10 years.
There has never been such a directional divergence, probably because the Fed has never been so far behind the curve as it is today. If the markets are priced correctly, they will quickly catch up next year, so it is possible that in 12 months", the 3-month/10-year measure will be flat as the Fed raises the benchmark policy rate and the short-term rate rises.
The conclusion is that the yield curve remains a strong indicator, at least a signal of a cooling economy.
Volatility should remain high and the criteria for investment success should be raised. But ultimately, we think it's worth taking the time to digest the bigger vision, rather than relying on any single metric.