Should stock investors fear a flat or inverted bond yield curve?

US stocks have been mostly down lately. Domestic stocks had largely defied the selloff seen in global markets for much of the year, but recently have given back most of their year-to-date gains. Some point to the slowdown as being caused by new tariffs resulting from trade disputes with China. Others suggest it is due to rising interest rates, primarily on the short-term end of the market.

Put simply, if the Fed wants to cool off the economy, they can raise the interest rates that banks pay for short term borrowing. Those higher costs are then passed on to borrowers, making people less likely to take out loans. Fewer loans equals less investment and spending, which leads to less economic activity. Usually, when the Fed is worried about a hot economy, long-term rates also rise as inflation concerns increase.

Sometimes, however, longer term interest rates stay down while the Fed raises short term rates. This is because longer term rates are market driven. If the market doesn’t collectively believe the economy is heating up enough to create inflation, then long term interest rates will typically stay low.

A yield curve gives a snapshot of how yields vary across bonds of similar credit quality, but different maturities, at a specific point in time. For example, the US Treasury yield curve indicates the yields of US Treasury bonds across a range of maturities. Bond yields change as markets digest news and events around the world, which also causes yield curves to move and change shape over time.

Historically, yield curves have mostly been upwardly sloping (short-term rates lower than long-term rates), but when short term rates and long-term rates are about the same, it is referred to as a flat yield curve. When short term rates exceed those with longer terms, it is called an inverted curve. Stock market investors get nervous as yield curves flatten. That is mainly because the central bankers seem to be trying to take fuel from a fire that the bond market considers to be under control. The fear for equity investors is that the Fed will totally extinguish the economy, sending us into recession.

So, are flat or inverted curves something to fear?

While the handful of instances of curve inversions in the US may concern investors, the small number of examples makes it difficult to determine a strong connection, and evidence from around the world suggests investors should not extrapolate from the US experience.

Exhibit 1 includes snapshots of the US Treasury yield curve on the last trading day of September for the last three years. Rates across the entire curve have generally moved higher since 2016. However, short-term rates moved at a faster pace than long-term rates leading to a “flattening” of the slope of the yield curve.

The US Market

Exhibit 2 illustrates growth of a hypothetical $1,000 investment in the S&P 500 Index since June 1976 plotted against the difference between 10-year and 2-year Treasury yields. This difference is referred to as the term spread[1] and is a commonly used measure of yield curve steepness. Also marked on the chart are the onset of the four periods when the yield curve inverted for at least two consecutive months, and short-term rates began to exceed long-term rates.

The inversion prior to the 2008 financial crisis is interesting to review. The US yield curve inverted in February 2006, after which the S&P 500 Index posted a positive 12-month return. The yield curve’s slope became positive again in June 2007, well prior to the market’s major downturn from October 2007 through February 2009. If an investor had interpreted the inversion as a sign of an imminent market decline, being out of stocks during the inverted period could have resulted in missing out on stock market gains. And if the same investor bought additional stock once the curve’s slope became positive, they would also have been exposed to the stock market weakness that followed.

Increasing the Sample

The small number of US yield curve inversions over the last 40 years makes it challenging to draw strong conclusions about the effect on stock market performance. We can, however, look at other countries to gain a better sense of the relation between inversions and subsequent market returns. Exhibit 3 shows the hypothetical growth of 1,000 of the country's local currency invested in the local stock market index the month before yield curve inversions began in five major developed nations, including the US, since 1985.

In 10 out of 14 cases of inversion, local investors would have had positive returns investing in their home markets after 36 months. This is not much less than the historical experience of these markets over the same time frame, regardless of the shape of the yield curve.[2] These results show that it is difficult to predict the timing and direction of equity market moves following a yield curve inversion.

Though the data set is limited, an analysis of yield curve inversions in five major developed countries shows that an inversion may not be a reliable indicator of stock market downturns. So, what can investors do if they are concerned about potential equity weakness? Develop and stick to a long-term plan that is in line with your risk tolerance, try to tune out the short-term noise, and focus on investing in a systematic way that will help meet your long-term goals.

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[1]. Term spread is the yield difference between bonds with different maturities but similar credit quality.
[2]. The data showed a 71% chance (10 of 14) of a three-year positive return following a yield curve inversion. To compare, we measured returns three years following every month-end between January 1985 and December 2014 in each of the five markets based on the local currency MSCI indices. The average chance of a three-year positive return in those five markets was 77%.

Adapted from Dimensional Fund Advisors LP November 2018 Issue Brief.

Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.

There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision.