Don’t Fear The Yield Curve?

In July of this year, James McCusker penned an article entitled “Don’t Fear The Yield Curve” in which he stated:

“There are always a lot of things to worry about in our economy — short range and long range. The yield curve, however. isn’t one of them. It just shows that some other people are worried, too. It doesn’t mean that they are right.”

I didn’t think much of the article at the time as it was an outlier. However, now, given the yield curve continues to trail lower, despite the many calls of “bond bears” swearing rates are going to rise, the number of voices in the “this time is different” camp has grown.

“Contrary to what many people think, inverted yield curves don’t always sound the alarm to sell. In fact, looking at the past five recessions, the S&P 500 didn’t peak for more than 19 months on average after the yield curve inverted, along the way adding more than 22% on average at the peak,” – Ryan Detrick, LPL

“In fact, an inversion is often a buying opportunity. During each of the past seven economic cycles, the S&P 500 has gained in the six-months before a yield-curve inversion.” Tony Dwyer, analyst at Canaccord Genuity.

First, the yield curve is simply the difference in the yields of different maturities of bonds. However, in this particular case, we are discussing the difference between the 2-year and the 10-year rate on U.S. Treasury bonds.

Historically speaking, the yield curve has been a consistent predictor of weaker economic times in the U.S. As James noted:

“The yield curve itself does not present a threat to the U.S. economy, but it does reflect a change in bond investor expectations about Federal Reserve actions and about the durability of our current economic expansion.”

Importantly, yield curves, like valuations, are “terrible” with respect to the “timing” of the economic slowdown and/or the impact to the financial markets. So, the longer the economy and markets continue to grow without an event, or sign of weakness, investors begin to dismiss the indicator under the premise “this time is different.”