By Justin Spittler – Casey Research USA,
What the heck is the inverted yield curve?
You might be asking yourself this question. That’s because everyone’s talking about it.
There’s a reason for this. The inverted yield curve is one of the most reliable economic indicators out there. It’s accurately predicted every single U.S. recession since 1957. It also tipped investors off before the last two major market meltdowns. It’s foolish to ignore it. This is especially true since this indicator could flash a major warning signal any day now.
• But first, let me explain the yield curve…
The yield curve plots the difference (or spread) between two interest rates. Usually, one yield is from a long-term bond. The other is from a short-term bond. In this essay, we’ll focus on the 10-year Treasury and 2-year Treasury yield curve (10y-2y). That’s because this yield curve has had an incredible track record of predicting economic slowdowns.
More on that in a second. But first, let’s look at this chart.
The blue line you see is the 10-year yield minus the 2-year yield. The gray bars represent the last three recessions which followed after the yield curve inverted (more on that below). Right now, the yield curve is above zero, as you can see. That’s normal because investors demand more money to lend money out over long periods. But notice what’s happened over the last few years. The curve’s been flattening. It’s now approaching zero.
• If it dips below zero, we will have what’s known as an “inverted yield curve”…
This would mean investors are getting paid less to lend money over 10 years than two years. That’s not normal… So why would it happen?
Well, many believe the yield curve inverts when investors get worried about the economy. And many investors take shelter in long-dated Treasuries when they’re nervous. That drives down long-term bond yields, which fall when bond prices rise.
Now, I realize I’m piling a lot of information on you in this essay. But the thing to remember is that an inverted yield curve can tip you off to impending softness in the economy.
And it’s historically done an incredible job of this. The 10y-2y yield curve inverted 22 months before the stock market topped out in 2007. The S&P 500 went on to plunge 57% over the next year and a half. And that’s just one example.
• The inverted yield curve has predicted the last nine U.S. recessions…
Again, that’s every major economic downturn since 1957. You’d be hard-pressed to find a more reliable economic indicator. That said, a return of the inverted yield curve wouldn’t mean that the economy’s going into a tailspin tomorrow. On average, it inverts 14 months before a recession begins. It’s also worth mentioning that the inverted yield curve tends to appear eight months before the stock market tops out, on average. So, an inverted yield curve doesn’t signal imminent danger. But it does act as an early warning sign.
• The good news is that the 10y-2y yield curve hasn’t inverted yet…
But it could any day now. To understand why, look at this chart. It shows the yield on the 10-Year U.S. Treasury.
You can see that the 10-year yield recently broke above 3%. That suggested we’d see higher yields on the 10-year, since this level had previously acted as strong resistance. But it didn’t hold above 3%. Instead, the 10-year yield fell below 3% and is now in free fall.
In other words, we likely just saw what’s known as a “false breakout.” And that means 10-year yields could fall rapidly from here. If the 10-year yield falls faster than the 2-year yield, the yield curve will continue to flatten… and eventually invert. And there’s good reason to think that will happen.
• U.S. stocks are looking weak…
The S&P 500 has fallen 9% since setting an all-time high in September. The Nasdaq is down 12%. And the Russell 2000, which tracks 2,000 smaller, publicly traded stocks, is down 16%. Meanwhile, the iShares 7-10 Year Treasury Bond ETF (IEF), which invests in intermediate-term U.S. Treasury bonds, is up 3% since early October. If money continues to shift from stocks to bonds, the yield curve will invert. And that would signal trouble ahead for stocks.
• So consider going on the defensive if you haven’t yet…
Here are a few ways you can do that…
- Lighten up on companies with a lot of debt. If the economy weakens, heavily indebted companies will struggle to repay their lenders. Those are stocks you want to avoid at this stage in the economic cycle.
- Hold extra cash (US$ dollar). Going to cash will also cushion you against big losses should stocks continue to slide. It will also give you dry powder to buy world-class companies on the cheap.