The stock market risk of an inverted yield curve

If the US yield curve inverts in 2022, it may signal that a recession is approaching and it may mean low returns for equities. Currently, the US yield curve is still sloped upwards, but it is flattening in places, largely because government bond yields between 3 months and 5 years have risen significantly, while the yield on durations of 10 years and over increased at a slower rate. That’s partly because many see the Fed raising rates in 2022. The result is a generally flatter yield curve, which could mean a reversal is coming.

Inverted Yield Curve Research

The ability of the US yield curve to predict recessions is reasonably well studied by scholars. This paper finds that the term spread, or the difference between 3-month and 10-year US Treasury yields, has historically been predictive of future US economic growth.

Therefore, even if the yield curve does not invert, the current flattening may be a sign that a slowdown in growth is on the horizon.

A predictor of recession

Perhaps even more powerfully, this paper shows that the US yield curve inversion has predicted all but one of the recent US recessions since the 1970s, and with no obvious false positives. The exception was the 1990 recession, although the yield curve was still relatively flat before the recession. The model also appears to work for many countries outside of the United States, with varying degrees of accuracy.

Important Warnings

There are, however, some important caveats. The first is perhaps that the slope of the yield curve is now a very well-monitored indicator. This can reduce its predictive power. For example, if the Fed bases some of its forecasts, and in fact its policy actions, on the shape of the yield curve, then the measurement may begin to change economic policy in a way that it did not by the pass.

Second, timing is an issue. The yield curve may invert before a recession, but a recession is rarely immediate. It is useful to know that a recession is approaching, but the stock market can rally between the signal and the recession, if one occurs. Moreover, the stock market is complex and can recover even in a recession, if this recession is factored into analysts’ forecasts.

So just because we know a recession is coming doesn’t mean the stock market is guaranteed to do badly. However, with the current US stock market still relatively high in historical valuation terms, there are reasons to be cautious.

Third, there are some nuances of implementation, exactly how you choose to measure the shape of the yield curve and the depth of a reversal are up for debate and there are disagreements on the exact process to follow.

There are therefore reasons to keep an eye on the yield curve in 2022 and to be wary of a possible inversion. However, predicting an upcoming recession, while not easy, may be easier than predicting the direction of the stock market.

About Nicole Harmon

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