Bull In Lake

Should You Fear a Yield Curve Inversion?

Bull In Lake

It makes perfect sense for investors to expect to be rewarded with juicier income streams for buying funds focused on bonds of longer maturities. After all, the amount of time someone is asked to hold a bond -- i.e., the length of time before it matures -- relates directly to how much risk is involved in owning a corporate or government IOU.

But such a correlation between longer- and shorter-term bonds hasn't always held up. Although few and far between, when this takes place -- say, a 10-Year Treasury note's yield falls below that of a sister 2-year note -- it's referred to as a yield-curve inversion. 

An inversion is a statistical term. In fixed-income parlance, it relates to a graph that compares a bond's different terms of maturity (plotted in years on the horizontal, or x-axis) against yields (plotted on the vertical, or y-axis). If a line is drawn connecting all of these data points, a curve is created.

A favorite exercise of many fund analysts is to compare a bond's 'yield curve' to those of another. Such a yield curve comparison between longer- and shorter-term bonds has most often been upward sloping with longer-dated bonds offering higher yields than shorter-dated issues.

When an inversion takes place, it simply means that bond risk-reward dynamics have changed so that a yield curve has transitioned from upward to downward sloping. This is important since a bond fund typically provides a regular stream of dividend income. Its yield is commonly expressed as a percentage comparing such an income stream (i.e., payout) to the fund's current trading price. 

Below is a chart showing yield curve movements over 43-plus years (June 1976 through July 2019). It compares yields for the 10-year U.S. Treasury note against those of the 2-year Treasury note. This is designed to show differences in yield between these government debt issues at various times along the curve.

When these yield gaps (e.g., spreads) are widening, the chart's curve rises. Conversely, when it falls, the 'spread' between yields is tightening. 

The black line running across the graph represents a zero spread. Movements below that point are periods when yield spreads were inverted and the 2-year note's yield was actually greater than the 10-year note's payout. 

Given that these instances happen so infrequently, we're presenting just a slice of the overall historical yield picture. This illustration isn't intended to be all-encompassing to pursue any specific trading strategy. Rather, we're trying with this chart to give you a better understanding of the nature of an inverted yield curve and any possible relationship to broader investment issues.  

Although not a typical development in most fixed-income markets, a dramatic change in yield curve slopes can lead to greater investment angst. Indeed, going back 40 years or more, inversions at different points in Treasury yield curves have been credited for inducing temporary sell-offs in stocks.1

Why stocks? Well, it turns out that a widely held belief in active management is that a bond market inversion is a strong signal of an upcoming recession. In particular, many point to yield "spreads" between the 2-year and 10-year Treasury as key to watch. By such reasoning, when those flip, it's time to sell equities.

Nobel Laureate Eugene Fama has investigated whether an inverted yield curve is really a good predictor of falling equity prices. Along with Dartmouth professor Kenneth French, he put out the first draft in July 2019 of research looking at the empirical evidence that sparks fear in the hearts of so many active investors.2

"Inverted yield curves, with higher yields on short-term government bonds, tend to forecast future recessions," the authors observe. "Perhaps because of this relation, some investors, fearing that an inverted yield curve predicts low stock returns, reduce their equity exposure when the term spread is negative."

Is such fear justified? "The answer is no. We find no evidence that inverted yield curves predict stocks will underperform Treasury bills for forecast periods of one, two, three and five years," write Fama and French.

The pair looked at data going back to 1975 and covering a range of different government bond yields of differing terms. Their research also considered several non-U.S. indexes, both in equities and fixed-income. "The results should disappoint investors hoping to use inverted yield curves to improve their expected portfolio return," summarizes Fama and French.

Regression analysis produced t-statistics -- a key calculation used by IFA's portfolio managers -- that were somewhat weaker for inversions and trading strategies over shorter forecast periods, according to the study. In general, however, a strong trend of "almost uniformly negative" average premiums generated by shifting stock allocations based on yield inversions actually acted to "reduce investors' expected return," conclude Fama and French.

Wes Crill, a vice president in Dimensional Fund Advisors' research group, has also looked into this subject. In 2018, he studied different inversions in the U.S. as well as four other developed markets going back to 1985. "The takeaway here is that it is difficult to predict the timing and direction of equity market moves following a yield curve inversion," the veteran analyst wrote in his research report.3

At IFA, we remain extremely skeptical of any strategy that invokes yield curve inversions as reasoning to bail out of stocks. Instead of trying to outguess cycles in any specific part of the market, our investment committee focuses on expected returns based on a bigger picture view of portfolio management.

In his own research, Crill summed up any perceived conundrum involving yield curve inversions this way:

"So, what can investors do if they are concerned about potential equity weakness? By developing and sticking to a long-term plan that is in line with their risk tolerance, investors may be better able to look past short-term noise and focus on investing in a systematic way that will help meet long-term goals."


Footnotes:

1. Dimensional Fund Advisors, "The Flat-Out Truth," Nov. 15, 2018.

2. Eugene Fama and Kenneth French, "Inverted Yield Curves and Expected Stock Returns," first draft, July 28, 2019.  

3. Wes Crill, Dimensional Fund Advisors, "What Does a Yield Curve Inversion Mean for Investors," Aug. 30, 2018.


This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful.  Investing involves risks, including possible loss of principal. Hypothetical data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such past or future performance.