Do Stocks Decline after Yield Curve Inversions?

In late March the yield on short-term bonds (3-month) was higher than longer-term bonds (10-year) for a week. Normally you would expect higher returns for offering a 10-year loan than for offering a 3-month loan, leading to an upward sloping curve of yields of bonds of different maturities. What we saw in late march is called a “yield curve inversion” – longer-dated bonds providing lower yields than shorter ones. This often occurs when the Fed raises short-term rates fast relative to current conditions, and can be a precursor to a recession. It was true in both 2000 & 2008. Should you expect a decline to start soon? No. There is usually a significant lag between the inversion and stock declines. Here are the returns between the inversion and the stock decline for the S&P 500 and Extended-Term Component (ET) in the 2 prior cases of 2000 and 2008:

Inversion 1 Peak 1 Duration S&P 500 Return ET Return
9/30/1998 1/31/2000 16 months +39% +165%
01/31/2006 10/31/2007 21 months +18% +95%

1 I used month-end dates, given better access to historic return data on a monthly basis. The missing/extra partial-month impact on the results should be minimal.

These ET surges that are typical leading to peaks are a reason for you not to be concerned, and even be optimistic. Additional thoughts:

  1. Leading to peaks, ET tends to significantly outperform the S&P 500. It is great for your risk plan to be in a much stronger position in the face of future declines.
  2. The recent inversion was very short-lived, and current interest rates are still very low historically. It is possible that a recession is even further away than typical after inversions.
  3. While the statistics above provide a reason for optimism, I continue to be prepared for declines at any point – there are no guarantees on timing and results in investing.
Disclosures Including Backtested Performance Data

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