Why the Inverted Yield Curve Shouldn’t Cause A Market Sell-Off, but It Might Anyway

On Wednesday, for the first time in over ten years, the yields on 2-year Treasury notes surpassed the yields on 10-year Treasury notes. This is unusual because under normal circumstances investors earn a higher rate of return for committing to a longer-term investment, but when short-term investments provide a greater return, it’s referred to as an inverted yield curve. The event is causing headlines for a more nefarious reason; a yield curve inversion has preceded the last seven recessions.

With many headlines reporting that the yield curve inversion is known to predict recessions, spooked investors fearing a repeat of the 2008-2009 recession drove the stock market down 800 points on Wednesday for its worst day of the year.

Why This Yield Curve Inversion Doesn’t Mean We’re On the Brink of Recession

While a yield curve inversion has predicted recessions in the past, this inversion might be a different story. First, we have to understand what helped cause the inversion.

Currently, uncertainty regarding trade agreements and tariffs have made investors cautious, even though most investors see the current trade issues as a temporary concern. When investors are cautious they tend to invest in more secure investments, like treasury bonds. Simple rules of supply and demand tell us that as more investors decide to buy long term treasury bonds, the lower the yields will fall. Additionally, now that our economy is more globalized we have to consider that very low interest and even negative interest rates in foreign countries have drawn outside long term investors to buy U.S. Treasury bonds, which drives their yields down even further.

On the other end of the curve, we have the yields on shorter-term treasuries. Interest rates on short term treasury bills and notes are more strongly tied to increases in the federal funds rate set by the Federal Open Market Committee. The committee sets the federal funds rate based on their view of the economy. Interest rates can be lowered to help spur a weaker economy or increased to slow down inflation if the economy is strong.

From 2008 until December of 2015, the Fed kept interest rates at 0% to help bring the economy out of recession. However, since December of 2016, the Fed steadily raised rates on eight occasions until they had reached 2.5%. Even though the U.S. economy was strong by almost all measures, increasing rates by 2% over just a 2 year period after 7 years of 0% interest, may have been too much of an increase too fast. Two weeks ago, the fed realized the error and cut rates to 2.25%, with additional cuts expected in the near term.

Because increases to the federal funds rate affects short term yields more substantially than longe term yields, the relatively steep increases by the Fed helped push short term yields higher. This eventually contributed to the yield on the 2-year note briefly surpassing the 10-year yield creating the inversion.

So in this incidence of the yield curve inversion, the circumstances leading up to it are not as closely tied to the economy as past occurrences. Recessions are inevitable. Historically, we are overdue for a recession. With that being said, consumer confidence is higher than average, retail sales continue to climb, and unemployment is at a near all-time low. None of these point to a looming recession.

Why A Recession Might Happen Anyway

A recession will happen. We just don’t know when. On average, the U.S economy goes through a recession every four years. It’s been ten years since the last one. So we know one will happen sooner or later. While the economic factors I mentioned above seem to indicate no recession is imminent, a recession can be sparked sooner than later if we start to believe in it just a little more.

Nearly 70% of the U.S. economy is driven by consumer spending. However, when people start to worry that a recession may be on the horizon, they cut back on spending. When consumer spending slows down, so does the economy. A recession is defined as two consecutive quarters of negative growth, so it wouldn’t take much to officially start a recession. As long as headlines keep talking about an impending recession, people will start to believe in it.

Why You Shouldn’t Be Worried

When a recession does follow a yield curve inversion such as the one that occurred this Wednesday, on average, the recession doesn’t start until about 15 months after the inversion according to Bank of America Merrill Lynch.

Additionally, in the time following an inversion, stock market returns are usually strong. Historically, the S&P 500 has returned 2.5% in the three months following an inversion, close to 5% in the following six months, 13.5% a year later, and 15% over two years. So while you might be itching to sell off your stocks and avoid the risks of a crash, in doing so, you’d also risk missing out on several years of gains.

The past can’t predict the future, but decades of stock market history demonstrate that nearly three out of every four years provide investors with positive stock market returns. Betting against the stock market in any given year, puts you against the odds.