Many investors pay close attention to the yield curve, which, in a common form, represents the difference between the 2-Year U.S. Treasury rate and the 10-Year U.S. Treasury rate. A yield curve inversion occurs when the 2-Year rate exceeds the 10-Year rate, and this has served as a signal for future trouble in the economy. In fact, every recession since the mid-1970s has followed an inverted yield curve (although it can take up to two years following the inversion for the recession to begin). And so, with the yield curve inverting on March 31, many market observers are wondering whether the inversion presages a stock market downturn.
Because recessions are typically associated with negative equity returns, this could persuade some investors to pull their money out of the market now. However, this brings up a few issues.
The first issue with this, though, is that the stock market often surges between a yield curve inversion and an eventual downturn. For example, the S&P 500 returned 28.4% between the December 2005 yield curve inversion and the beginning of the bear market in October 2007.
More broadly, looking at the six yield curve inversions since 1978, 1-year returns following an inversion average 4.7% compared to 9.0% in all other 1-year periods, and annual returns two years out average 4% compared to 8% for other two-year periods. And while those looking to avoid below-average stock market returns might turn to bonds for relative strength in these periods, it turns out that 5-Year U.S. Treasuries underperform U.S. stocks on average in 1- 2- and 5-year periods after an inversion (suggesting that while below-average stock returns might be on the horizon, moving to bonds is not necessarily an attractive alternative).
In the end, the recessions (and any associated stock market declines) that follow yield curve inversions can be thought of as the price investors pay for participating in the market (and the strong returns associated with non-recessionary periods). While history suggests that you might not want to make dramatic changes to your portfolios because of the recent yield curve inversion, it can be an opportunity to consider whether your portfolios are aligned with your objectives and risk tolerance to get ahead of a potential market downturn in the years ahead!
Because recessions are typically associated with negative equity returns, this could persuade some investors to pull their money out of the market now. However, this brings up a few issues.
The first issue with this, though, is that the stock market often surges between a yield curve inversion and an eventual downturn. For example, the S&P 500 returned 28.4% between the December 2005 yield curve inversion and the beginning of the bear market in October 2007.
More broadly, looking at the six yield curve inversions since 1978, 1-year returns following an inversion average 4.7% compared to 9.0% in all other 1-year periods, and annual returns two years out average 4% compared to 8% for other two-year periods. And while those looking to avoid below-average stock market returns might turn to bonds for relative strength in these periods, it turns out that 5-Year U.S. Treasuries underperform U.S. stocks on average in 1- 2- and 5-year periods after an inversion (suggesting that while below-average stock returns might be on the horizon, moving to bonds is not necessarily an attractive alternative).
In the end, the recessions (and any associated stock market declines) that follow yield curve inversions can be thought of as the price investors pay for participating in the market (and the strong returns associated with non-recessionary periods). While history suggests that you might not want to make dramatic changes to your portfolios because of the recent yield curve inversion, it can be an opportunity to consider whether your portfolios are aligned with your objectives and risk tolerance to get ahead of a potential market downturn in the years ahead!
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