What Does Inverted Yield Curve Mean? A Long Rally, then a Recession

You’ve probably heard by now that the bond market flashed a very unwelcome signal for the economy last week: an inverted yield curve, meaning that interest rates on long-term government debt fell below short-term yields. History shows that when long-term bond yields dip below short-term yields, a recession eventually follows. However, between the onset of an inverted yield curve signal and the recession it typically portends, good things tend to happen for stocks.

According to research firm LPL Financial, a U.S. recession didn’t arrive for an average of 21 months after the yield curve inverted. The average returns in the S&P 500 during those 21 months? 12.7%.

Here are the stats broken down by year (table courtesy of LPL Financial and FactSet):

Here's what the inverted yield curve means for stocks, historically.Obviously there’s good news and bad news here.

The good news is that those panicky headlines about a recession being imminent are a bit premature. The five times the inverted yield curve signal has flashed in the last 40 years, the quickest a U.S. recession has followed was in 1980-1981, when there was an 11-month lag between the two. The longest gap between a yield curve inverting and a recession commencing was from 1998 to 2001, a nearly three-year gap between the two.

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Using that data, we should expect another recession no earlier than next February, and as late as 2022. In the meantime, stocks should fare quite well—they’ve never fallen in the time between the onset of an inverted yield curve and the start of the ensuing recession, rising as much as 28.5% in one instance.

The bad news, of course, is that a recession now seems likely. According to the San Francisco Federal Reserve, a negative curve has forecast all nine previous U.S. recessions. The prospect of an impending recession is daunting for all investors. But a decade removed from the last U.S. recession, and with poor economic data in Europe, China and elsewhere, and just 20,000 jobs added to the U.S. work force in February, the writing of another recession has been on the wall for a while—inverted yield curve or not.

What to Make of the Inverted Yield Curve

In fact, Tom Hutchinson, chief analyst of our Cabot Dividend Investor advisory, has been telling his subscribers a recession is nigh for quite some time. Here’s what Tom wrote in his update last week – before the inverted yield curve flashed:

“Look at the recent market behavior. In December the market was crashing. We came within a whisker of a bear market, down 19.8% from the high. Since then, the market has surged 20% higher, up 13% so far this year and now less than 4% from the all-time high. The only tangible difference in this tale of two markets is the Fed.

“The Fed announced a new policy of ‘patience’ and indicated that it will stop raising the Fed Funds rate for now. Apparently that made all the difference, because all the other problems that spooked the market in December are still with us. The global economy still stinks. There’s still no trade deal with China. And it is still an open question what this year’s earnings will look like.

“To investors, the Fed announcement pushed the next recession further into the future. And the market transformed from suicidal to euphoric on a dime. But where do we go from here?

“I see three possible scenarios as most likely. One, the economy slows more than expected for the reasons mentioned above. That’s not good. That would put a near-term recession and bear market back on the table. Two, the economy is stronger than expected. The problem with that is that it would likely reignite the Fed to start raising rates again. Either the economy slows all by itself or the Fed will induce decline.

“Of course, it’s also possible that the economy is strong enough to stay out of the doghouse but not strong enough to prompt Fed action. This is probably the best-case scenario for the market.”

While Tom’s “best-case scenario” of no recession and no Fed action seems less and less likely, it’s doubtful a recession is close enough for stocks to start cratering now. Markets got spooked last Friday, tumbling roughly 2% after the yield curve inverted. But they stabilized on Monday, and are likely to keep chugging forward for the intermediate term.

If you believe the history of inverted yield curves, we could have another 21 months (give or take) before we have to start battening down the hatches in preparation for another recession. Until then, there’s money to be made, and good stocks abound.

I recommend you take advantage of it while you can!

Chris Preston

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Investment analyst and Chief Analyst of Cabot Wealth Daily, Chris Preston brings you all the latest from the investing world. Sign up to get updates and breaking news delivered FREE to your inbox. Get unlimited access to our library of complimentary investing reports.

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