The US Yield Curve Inverted! Should Investors Underweight Risk?
Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
No, we don’t think so. Although an inverted yield curve is not a sign we welcome, it also is not a clear indicator of an imminent equity market downturn. Instead of underweighting risky assets, we suggest investors take this opportunity to refresh plans to manage through the next bear market.
Late last month, the yield spread between ten-year Treasury notes and three-month Treasury bills turned negative for the first time since late August 2007. Precipitated by a steep decline in yields of long-term Treasuries, the inversion followed the Federal Open Market Committee’s sharp downward revision to the dot plot, indicating the majority of participants no longer anticipated rate hikes in 2019. The Fed’s substantial change in outlook could be read as a tacit admission that its December rate hike had been a potentially harmful mistake.
Well-rooted concerns about an inverted yield curve only added to the Fed’s sobering outlook. At a basic level, the prospect of earning higher rates of return for tying up capital in shorter-duration instruments runs counter to economic thinking. The typical rationale given for this anomaly involves investors bidding Treasury bond yields lower amid concerns about the economic outlook. Indeed, the yield curve inverted prior to each of the last seven US recessions since the late 1960s, with two false positives in 1966 and 1998. Few singular metrics have such a track record.
Yet, we do not think investors should underweight risk at this time. While yield curve inversions have typically led economic downturns by roughly one year and equity markets have frequently peaked prior to the onset of an economic downturn, the data available are few and highly variable. In other words, empirical inferences about yield curve inversions should be taken with a grain of salt. Consider that US equity markets have tended to remain buoyant following an inversion, returning, on average, around 6% to investors in the subsequent 12-month period.
Other data also appear to be inconsistent with an impending recession, even if they suggest a softening outlook. Recent data on new orders for core durable goods, retail sales, and industrial production are all higher than year-ago levels. Similarly, initial unemployment claims remain close to all-time lows. To be sure, economic data is often a lagging indicator of conditions. But, at least one of these prominent indicators usually flashes red prior to a downturn. Timelier market-based data like corporate and high-yield credit spreads aren’t signaling stress either.
Further, two characteristics of the current market may also make this inversion unique. First, the world remains mired in low- and negative-yielding debt, anchoring US rates. Last month, the European Central Bank acknowledged deteriorating economic conditions and revived its program of providing longer-term liquidity provisions to banks, pressuring rates lower. By the end of March, ten-year German Bund yields retreated into negative territory for the first time since mid-2016. Second, China is likely to dictate the course of the business cycle to a greater degree than previously. While China’s economic growth is certainly moderating, it remains supportive of global cyclical conditions.
Still, the late stage of the economic environment suggests investors should refresh plans to manage through the next equity market downturn. For starters, investors should have a thorough understanding of the various types of risk embedded in their portfolios, such as geographic, factor, or sector exposures, to avoid any unintended bets. Supplementing this work with stress tests can be a helpful way to better understand how extreme economic or financial conditions could impact portfolios. Asset owners with spending needs should also consider how their liquidity might change in a downturn.
An important challenge for investors—even those investors with the best-laid plans—will be to guard against behavioral biases. For instance, loss aversion may complicate some investors’ efforts to fully participate in an equity market recovery, if they previously reduced exposure. The most successful investors seek to guard against behavioral biases by crafting thoughtful plans and sharing them with relevant stakeholders in advance of market stress. Ultimately, preparedness is what separates many top investors from the rest of the field.
Kevin Rosenbaum, Deputy Head of Cambridge Associates’ Capital Markets Research