Afraid of the yield curve? You’re looking at the wrong one

When bond yields flatten to current levels before a recession, the S&P often posts gains

Shareholders constantly live up to their reputation as flighty irrational beings prone to panic and wild abandon. What is odd is that so many have come to view their counterparts in the bond market as stolid and sensible forecasters on whose views they can rely.

The kerfuffle about the yield curve is a primary example of the division. This week the gap between long- and short-dated U.S. Treasurys reached its lowest in more than a decade, with one version – the five-year minus two-year yield – turning negative. Stocks have sold off hard, as investors fear such so-called inversions of the yield curve presage recessions (every recession since the 1950s was foreshadowed by an inverted curve).

For investors there are two important questions. First, is the yield curve really telling us that recession is looming? Second, what should we do about it?

The case for being scared of yield curves appears strong in the U.S. because they have sent few false recession signals and lots of correct warnings. Still, it is unclear why the curve should matter, or which gap matters most.

Until now no one paid attention to the five minus two, with markets watching the 10-year minus 2-year yield and academics tending to follow the 10-year minus the 3-month Treasury bill yield.

A model developed by the New York Fed based on the 10-year minus 3-month yield puts the recession probability over the next year at roughly 15%, higher than in the past few years but still low.

The market’s favored 10year-2-year spread isn’t flashing red, either.

With a gap of 0.11 percentage points on Wednesday, it was last at these levels and falling in November 2005 – two years before the recession, and a great time to own stocks, at least for a while.

That doesn’t mean the yield curve is telling us nothing. Longterm yields offer a rough guide to what investors think will happen to long-term growth and inflation. If short-term yields are higher, one interpretation is the Fed’s about to make a mistake by raising interest rates too much and cause a recession. An inverted yield curve may also push lenders away from long-term loans toward more-profitable short-term debt, restricting access to finance and impacting the economy.

At the moment the yield curve tells us that investors think we are in the late stage of the economic cycle, and interest rates aren’t all that far from peaking. This isn’t a surprise, as almost everyone agrees, including the Fed.

Some at the Fed and elsewhere argue that this time is different, because long-term bond yields are suppressed by the Fed’s postcrisis bond buying program, known as quantitative easing, or QE. This doesn’t stack up as an argument, though.

It is true that when the effects of QE are stripped out by using NY Fed estimates of the socalled “term premium” to split off certain supply and demand factors, the underlying longdated bond yield would be higher and so the yield curve steeper. But it turns out that without the term premium, the yield curve offered no warning of most recessions, and was inverted for more than half of the past halfcentury. In other words, it doesn’t really tell you anything useful about impending recessions.

The investment implications of a flat or even an inverted curve aren’t obvious.

The time to recession from inversion in the past has varied from a few months to more than two years. Buying the S&P 500 on the day of the first prerecession inversion of the 10-year-3month spread led to 12-month price returns varying from a loss of 21% after February 1973 to a gain of 37% from September 1998.

When the yield curve flattened to the current, still not inverted, level of the 10-year-3-month spread before each of the past seven recessions, the S&P went on to gain over the next year in five cases, and lost in only two. The curve was also this flat a few times where no inversion or recession followed and stocks did well, such as in the mid-1990s.

Past experience is no guarantee of the future. And Japan’s example suggests that in a lowinterest-rate world, recessions might hit without any warning from the yield curve. Still, investors shouldn’t panic purely on the basis of what the yield curve is telling them.

That said, it makes sense, as it has for a while , gradually to shift to a more defensive stance as the economic cycle matures. That might mean getting only part of further gains before recession eventually hits, but it also means being better prepared when the big drop happens.