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Normally, bond investors require higher returns to own longer dated bonds. This explains why ninety five percent of the time, 10-year Treasury bond rates are higher than 3-month T-Bill rates based on monthly observations  back to 1982. The other five percent of the time, bond investors have bid up long-term Treasury bonds to such an extent that the yield on those bonds fall below short-term bills. This situation is commonly known as an “inverted yield curve” and has a strong track-record as a predictor of recessions. The chart below shows that inverted curves existed before each of the last three recessions. The current spread between the 3-month T-Bill and 10-year Treasury bond is just below 0. If it stays here or falls further by month end, it will mark the first monthly inversion since 2006.

A Closer Look at Past Inversions

There are only a handful of times where the curve was inverted as it is today, and in none of these times were the conditions exactly the same as they are today. Still, it is worth reviewing what happened to financial markets and the economy following an inversion. As you can see in the table below, there can be a considerable lag between the time an inversion began and the peak in the stock market or the start of recession. Let us take a closer look at each of the last three inversions.

1989-1990: In 1989, at the tail end of the 1980s savings and loan crisis, the Treasury curve inverted in June, turned positive through September and October, and finally re-inverted in November 1989. The stock market continued an upward climb for another ten months until June 1990, and the economy finally entered a recession in July 1990. All of this took place as the United States became involved in the first Gulf War.

2000-2001: July 2000 saw the next curve inversion which lasted until January 2001. This was a period of great tumult and disappointment as the technology-led stock rally of the late 1990s came to a spectacular halt. Following the initial inversion in July 2000, it took 9 months before a recession was officially signaled.

2006-2007: After an initial curve inversion in August 2006, the stock market continued to climb. The S&P 500 finally peaked 15 months later in October 2007, but not before returning over 20% to investors. The U.S. economy then officially entered a recession in December 2007 as the global financial crisis took hold.

3-month Treasury Bill Yield Minus 10-Year Treasury Bond Yield
SubsequentRecession
Date Range of InversionPeakStart Date
===========================
June 1989-December 1989Jun-90Jul-90
(10 months later)(11 months later)
July 2000-January 2001Aug-00Mar-01
(1 month later)(9 months later)
August 2006-May 2007Oct-07Dec-07
(15 months later)(17 months later)
Source: WCA, Bloomberg, National Bureau of Economic Research Recession Dating Committee

Impact of Inversions

There are three main reasons why a curve inversion can hurt the economy and market performance.

First, higher short-term rates put in place by the central bank to cool the economy cuts into disposable income, reducing spending throughout the economy. This can be seen when households and businesses, who financed asset purchases with short-term, adjustable rate debt, are forced to pay higher interest costs as loans reset or are refinanced.

Second, the “hurdle rate” for some new projects may rise due to higher short-term rates, leading some businesses to forego some projects, thereby dampening economic growth.

Third, leveraged financial firms will see a decline in returns due to higher funding costs. Confronted by lower profits and reduced incentive to take risk, some firms may sell assets and reduce leverage. This concept can apply to both banks (reduced lending) and investors such as hedge funds (reduced arbitrage).

Overall, the fact that investors in long-term bonds are suddenly willing to accept a return below the return available on short-term bonds usually indicates that concern over growth is on the rise.

Portfolio Implications

It is important to both acknowledge the potential risks that the bond market is conveying here. An inverted yield curve both reflects a forward view that is not consistent with steady economic growth and has the ability to change incentives in the economy in such a way to directly lessen growth. However, we have seen that there can be significant lags between past inversions, market declines, and recessions. Moreover, the fact that we have relatively few data points to work with, because inversions are not the normal state of things and only occurred about 5% of the time in the past 40 years, tells us we must find additional corroborating evidence before taking an investment action based on the curve inversion alone. Should our WCA Fundamental Conditions Barometer confirm weakness, we will not hesitate to make tactical adjustments.

We also note that adjustments within the core of portfolios may also be appropriate if other data starts to confirm a higher recession probability. Treasuries would be preferred over junk bonds, corporate, and REITs, for example. Defensive sectors such as healthcare and consumer staples also would be preferable to economically sensitive sectors such as technology and industrials.

Kevin Caron, CFA, Senior Portfolio Manager
Chad Morganlander, Senior Portfolio Manager
Matthew Battipaglia, Portfolio Manager
Steve Lerit, CFA, Client Portfolio Manager
Suzanne Ashley, Analyst

(973) 549-4168

www.washingtoncrossingadvisors.com
www.stifel.com


Disclosures

WCA Fundamental Conditions Barometer Description: We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. The analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.

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