The headlines and TV pundits have been screaming about the terrors of the inverted yield curve. After the yield on the 2-year U.S. Treasury note rose above the 10-year last Wednesday, a mini-panic ensued. Equity markets fell about 4% at one point after the 2-yr-10-yr US yield curve went negative, but have since recovered (see page 1).

It’s the newest thing and bad news sells, of course, and it sells well. But what if the bad news is a head fake or just plain uninformed? A look at history often gives investors the context needed to make a knowledgeable decision.

This is the third panic in markets as the US curve experienced various inversions, going back to the fall of 2018, just before the Christmas bear market. There was an inversion of the 1-year-5-year curve in November, when the market fell 16%, and then the 3mos.-10-yr inversion last March. The market lost 3%. Now you have the twos and tens inverting. The great market freak-outs over yield curve inversions are highlighted below.

Inverting curves are not associated with normal circumstances. I get that this is a potential issue. Obviously, there is something troubling markets, evidenced by not only the widening inversions in the U.S. treasury yield curve but the widespread negative rates outside the U.S. (more than 27% of global sovereign bonds negative yield, or about $16 trillion). But here’s the history: previous 2-yr – 10-yr inversions going back to 1976 have predicted 22 of the 5 recessions. So you can see why I am not convinced that a recession automatically ensues or that stock selling is justified. Moreover, on the occasions when a contraction did follow the average time from inversion to recession was 20.5 months, with the shortest being 10 months lead time.

Don't Panic Over Yield Inversion; US Stocks Attractive
Source: FS Insight, Bloomberg

Secondly, a plunge in the 10-year note that drove an inversion has only happened once, in 1998, the only year out of five 2-10 inversions in which both yields were dropping— as now. The other four times were due to rising 2-yr rates. This should matter to investors because those other four inversions stemmed from Federal Reserve Board tightening and driving up front end. Sounds familiar, doesn’t it? This 2019 inversion is due to the collapse in 10-yr rates, and like 1998, stems from a global risk-off trade. Back then, it was the Long-term Capital and Russian debt crisis.

Separately, I think there’s also juice in long term bonds, which have become a momentum trade. Multiple factors are strengthening the belief US interest rates could go to zero. If rates continue to drop, the 30-yr bond, for example, could rally 55%, the 10-yr 15%, but the 2-yr a mere 3%. Macro funds and momentum investors will be buying long-term bonds on this belief, further amplifying the inversion of the yield curve.

Again, context is important. Investors should also note that in Germany and Japan, there has been this momentum bond trade but stocks have risen, too. Those countries with big gains in their 30-yr bonds also saw big gains in equities.

Why interest rates are falling actually matters. This risks “over-simplifying” markets, but I’d like to provide a conceptual framework: Are falling interest rates due to deflation risk rising (i.e., business cycle slowdown), or this is a chase of lower rates/ momentum trade (add in “risk-off”). If the latter is this case, we should see lower “real” interest rates and this should be positive for equities. Zero interest rates are prevalent around the World, why not see it in the U.S.?

Don't Panic Over Yield Inversion; US Stocks Attractive
Source: FS Insight, Bloomberg

Here’s some more interesting history. Short term S&P 500 typically rallied after initial 10y-2-yr inversion. The S&P 500 index managed gains five of five times following the first inversion of the 2-yr-10-yr notes (the 2-yrs trade only since 1976), with an average further gain of 23%. In the last three occasions, stocks gained an average 33%, spanning 16-19 months before topping out. This doesn’t sound like a time to be selling stocks.

The reason for the doom headlines is that recessions did follow five of the 2-yr-10-yr inversions. But what’s the predictive power of the 2-yr-10-yr inversion those five times when a recession followed? Weak is the answer. After each of the five inversions that were followed by a recession, it took at maximum 34 months and at minimum ten months for the recession to materialize. Ultimately, those who sell shares now could miss out on big gains, even if a recession arrives in late 2020.

Mind you, after all of the sturm und drang last week, the 2-yr-10-yr curve returned to positive territory, albeit minimal, at a few basis points. In terms of strategy, note that cycle stocks led three of five times after the 2-yr-10-yr inversions (in 1998, cyclicals underperformed but technology outperformed in a big way) and cyclicals trailed in 1978 (stagflation period).

What could go wrong? Global macroeconomic risks are elevated. Currently, the biggest concern is an escalation of trouble in Hong Kong and the threat of a mainland Chinese response.

Bottom line: Inversion of the yield curve has caused markets to re-think their positions. The “zero rates” risk in the US creates a momentum trade to buy long-term bonds, potentially amplifying the inversion. We believe this mirrors 1998 and see this as a buying opportunity. Cyclicals worked 3 of 5 times we saw a 2-yr-10-yr inversion.

Don't Panic Over Yield Inversion; US Stocks Attractive
Figure: Comparative matrix of risk/reward drivers in 2019
Per FS insight
Don't Panic Over Yield Inversion; US Stocks Attractive
Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019

More from the author

Disclosures (show)

Stay up to date with the latest articles and business updates. Subscribe to our newsletter

Articles Read 1/2

🎁 Unlock 1 extra article by joining our Community!

Stay up to date with the latest articles. You’ll even get special recommendations weekly.

Already have an account? Sign In

Don't Miss Out
First Month Free