Implications of inverted yield curve for equities

More good stuff from Mike Panzner

"On the heels of this morning’s weaker-than-expected jobs report, the U.S. treasury yield curve has flattened, with the difference between 10-year and 2-year treasury note yields falling by 2 basis points to a 4-year low of 36 basis points.

This continues the trend that began on July 29, 2003, when the spread peaked at a 30-year high of 275 basis points. The continuing decline has recently led to increasing speculation that the yield curve will soon become "inverted."

Interestingly, while some argue that an economic environment where shorter-term yields are higher than longer-term yields is bad for stocks, the historical record is mixed.

In the seven periods over the past 30 years when the spread between 10-year and 2-year notes has been negative for the most part of a month or more, the S&P 500 has risen four times and fallen three.

The biggest gain occurred in a near 6-month span that ended in June 1989, when
the S&P 500 Index rose by 15.70%. The largest loss was seen in 2000, when the
measure fell by 5.32% from February to December.

For what it’s worth, a quick read of the pattern over the past three decades
does suggest that when the yield curve remains inverted for an extended period
of time, equity returns turn out to be less than stellar.

click for larger chart


Period when 10-year
/2-year spread has
been negative           S&P 500 Gain/Loss

8/18/78 – 5/1/80            +0.70%
9/12/80 – 11/5/81          -1.59%
1/14/82 – 7/16/82          -3.87%
1/13/89 – 6/29/89           +15.70%
8/11/89 – 10/11/89         +3.55%
  6/9/98 – 7/9/98            +3.60%
  2/2/00 – 12/28/00         -5.32%

What's been said:

Discussions found on the web:
  1. jjr commented on Jun 4

    What’s the S&P500 and Dow performance in the twelve months trailing the start of an inversion of the yield curve? I believe that is a much more interesting data point than the performance during the inversion.

  2. jjr commented on Jun 4

    I looked closer at that chart and those dates. Doesn’t look to change much to go out a year, since a few of those periods are greater than one year and S&P has mostly been up during that 30 yr. period. Need to read more about this.

  3. spencer commented on Jun 5

    The problem is one of multicollinearity. A negative sloped yield curve is accompanied by rising inflation — when the curve is negative inflation is virtually always higher then unemployment. So the question is what is the true causal relationship that makes the market negative — a negative slope or higher inflation?

    I knew many managers that got caught by the 1987 crash because they were waiting for the curve to turn negative.

    Isn’t it just another example of the need to use multiple indicators. No one indicator is perfect — they all fail at one point or another. But when you get the vast majority of different indicators giving a sell or buy signal you should pay attention.

  4. stanley commented on Aug 26

    The UK yield curve has been inverted for some time. The reason is that UK pension funds are/have been buying long gilts in comparison with equities because of the problem of underfunding. While this is purely technical it might well mask the prospect of slower growth and lower inflation.

    Any thoughts?

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