What the US Yield Curve Inversion means for Stocks

An indicator that has a 10 by 10 record of correctly predicting an impending recession certainly gets a lot of attention when it starts flashing.

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What is a yield curve inversion?

Simply put, the yield curve represents a line on a chart connecting the different interest rates for each bond maturity. The longer the bond, the more the interest rate should be. When that changes and a shorter-term bond has a higher interest rate than longer-term bonds, that's called an inversion. It means that investors are expecting higher interest rates in the short term, but lower interest rates in the future. Why would there be lower interest rates in the future? Because investors expect the Fed to cut rates to fight a recession.

The theory focuses on the 2 and 10-year Treasury bonds, and yesterday that inversion reached the largest degree since 2000 (when yield curve inversion predicted the dot-com recession after the Fed raised rates to deal with higher inflation).

It isn't the first time that the curve inverted recently, it should be noted. A few months ago, when the Fed started raising rates, the curve also inverted but popped back. There were several media articles at the time downplaying the inversion, but now we are in a bear market, everyone is paying attention!

What does it all mean?

In the last ten recessions (including the pandemic-induced one), the yield curve inverted two years before the recession happened. So, it doesn't mean that a recession is about to happen right now; but it is a really strong signal that one could be about to happen soon.

It's a strong indicator because it is a market signal - not what economists (who often get it wrong!) are forecasting. The 10-year yield doesn't move on a whim. For example, yesterday JPMorgan reported it was increasing its loan-loss provisions ahead of a possible recession where a higher number than usual of bank loans would go unpaid, after its CEO Jamie Dimon a few weeks ago said he expected a "hurricane" in the economy.

It should be noted that yield curve inversions have happened without there eventually being a recession but every recession was preceded by a yield curve inversion.

Yield curve vs S&P 500

The 10-year minus 2-year yield chart below signals a recession every time it goes below the zero line. Most recently, in August of 2019, the 10Y-2Y flashed a recession signal five months before it ensued (top left), causing a recession in February of 2020. The SP500 plummeted 35% over a period of a single month as a result (bottom left).

If history was to repeat, a recession should occur in September of 2022 as the last inversion before July was in April this year. However, given the inversion frequency, which did not appear in 2020, this time might be shorter. A similar decline in the SP500 could trigger a leg down to around 2500 from current levels, or 35% below its pre-crash top.

Source: Spreadex trading platform

Key takeaways

Yield inversions focus on the 2 and 10-year bonds. The 10 minus 2 yield inverted back in April, and popped back when the Fed started raising rates. Now, it has flipped to negative again, signaling an upcoming recession. In the last 10 recessions, yields inverted before the recession started.