Yield curve inversions have long been seen as a harbinger of economic downturns. This article delves into the history of yield curve inversions, focusing on the 10YR/2YR  curve, by examining market performance during and after inversions. 

"Because I was inverted."
- Maverick, Top Gun

As a quick primer, a yield curve represents the difference in yields of similar bonds, such as US Treasuries, across different maturities. This is often defined as the spread between two maturities. Normally, the spread is positive reflecting a higher yield on the longer-term bonds. The yield curve is said to be inverted when that spread turns negative, yielding higher short-term rates than long-term.

The following tables list the inversion bottoms for the 10YR/3MO and 10YR/2YR yield curves since 1983 along with their depth and overall durations. Today, we are in the midst of an inversion that began on July 5, 2022 for the 10YR/2YR, potentially bottoming on March 8, 2023.

Historically, there have been several notable yield curve inversions, with varying levels of severity and duration. While not every inversion leads to a recession, it is important to note that every recession in recent history has been preceded by a yield curve inversion. On average, a recession occurs approximately 18 months after an inversion of the 10YR/2YR curve, though this timeframe has ranged from 10 to 36 months. Over the last five recessions, excluding the COVID pandemic, that timeframe has been reduced to 13 months. We are presently 10 months post-inversion.

The stock market generally appreciates between the start of inversion, through the bottom of inversion, until the onset of a recession. For instance, during the Great Recession, the 10YR/2YR curve inverted in December 2005, bottoming on November 16, 2006. The recession began in December 2007, where the S&P 500 rose by 24.1% prior.

Through the early 1990s recession, which shares similarities with current conditions, the S&P 500 saw a gain of 29.5% in the 15 months post-inversion. During the dot-com bust and the subsequent early 2000s recession, the S&P 500 gained 11.1% over the 8 months prior to recession. The average return following an inversion to the market peak is 22%.

The recession of the early 90’s is the most recent that has several parallels to current conditions. Inflation pressures at the end of a long peacetime expansion caused the Fed to start a rate hiking cycle from 1988-89. This combined with debt accumulation in the late ‘80s and a weakened consumer sentiment were ultimately the cause for this recession. The 1990 oil price shock is sometimes credited with starting the recession, however that event occurred due to the Iraqi invasion of Kuwait on 2 August 1990. Preceding this recession, the yield curve inverted in December of ‘88 with the economic contraction beginning July of 1990. 

Further parallels from 1990 to today are the stock market correction leading into the yield curve inversion along with an ongoing banking crisis. In the late ‘80s & early ‘90s this was the savings and loan crisis. Today we are dealing with the aftermath of the collapse of Credit Suisse, Silvergate, Silicon Valley, and Signature Banks. In both cases this was brought on by rapidly rising rates causing an asset-liability mismatch at those institutions. In 1987, the S&P 500 experienced a 30.3% correction. Presently, the S&P 500 contracted 25.4% from the peak in January to a bottom in October of 2022. In contrast to the early 1990s, the current inversion had started at the conclusion of the correction, providing this post-inversion market with less time to run.

The best-performing sectors in this late-stage period have tended to be utilities and energy, which have averaged a 24% and 17% return respectively following inversion. In the current environment, Utilities (XLU) are approximately flat on a total return basis and the best performing sector has been Energy (XLE). Areas to avoid include banking and financials, as long-term lending against short-term deposits becomes less profitable during inversions. With the recent fallout of bank failures, this is all the more evident.

Timelines of an Inversion

Observations of prior cycles often highlight the duration of time between the initial inversion of the yield curve and the onset of the following recession. As stated above, this occurs, on average, approximately 18 months following the inversion of the 10YR/2YR curve, with a range from 10 to 36 months. Another metric to study is the duration from the bottom of inversion to the onset of the recession. 

The durations from the bottom of curve inversion to onset of the next recession have been 12, 3, 16, 11, and 12 months respectively for the early ‘80s double dip, early ‘90s, dot com bust, and financial crisis recessions. This leads to a mean duration of 9.5 months from bottom to outset of recession. 

The 10YR/3MO demonstrates a similar pattern, albeit with the inversion bottom occurring closer to the onset of economic contraction. These durations were 0, 4, 11, 1, and 7 months respectively for the early ‘80s double dip, early ‘90s, dot com bust, and financial crisis recessions. The mean time from bottom to recession is just 5 months. By the time you notice this indicator bottomed, it is likely time to start exercising caution.

If we are to assume, and as of this writing, that the yield curve inversion bottomed on March 8, 2023 then the likelihood of a recession starting on or about January 2024 according to this indicator is fairly significant. 

Source: Federal Reserve Bank of St. Louis, ‘A Look at Fed Tightening Episodes since the 1980s’

According to the St. Louis Federal Reserve, economic expansion often peaks 15 months after the last rate increase. Presently, the rate hike cycle began in March 2022. If the FOMC stops hiking rates in the fall of 2023 as expected, the cumulative tightening will be 500 bps or more. This may have already resulted in over-tightening due to the fight against high inflation, being the largest Fed funds rate hike since 1980 under Paul Volcker. Based on these timelines, the resulting recession could potentially commence around the fall of 2024. However, our belief is the FOMC conducted their rate tightening action too late in the cycle and this should be taken into account.

These two metrics taken together would suggest that our chances of entering an economic recession by early to mid 2024 are very good. However, while yield curve inversions can provide valuable insights into potential economic downturns, it is essential to consider the broader market context and other factors that may influence market performance. As it has been said, “history doesn’t repeat itself, but it often rhymes”, every situation will have its own unique nuances.

Timing the Market

While timing the market is a fool’s errand, let’s indulge. In three of our four prior examples, the S&P 500 appreciated through inversion and topped prior to the onset of recession. In 1980 and 2000, the market peaked exactly four months before the US entered a recession. In 1990, this was just 2 months. In 2007 the market continued to climb until just as the recession was beginning.

As the table above illustrates, the S&P 500 continues to climb following the yield curve setting an inversion bottom. The mean market gain from the initial inversion is 25.3%, with 9.7% of that gain occurring prior to the bottom of the curve. 

Significant gains can be made following the bottoming of inversion, however it would feel a bit like playing with fire as history would show that a downturn is very likely to swiftly follow. The current market sentiment is typified by headlines such as “Stocks Brush Off Financial Sector Risks” and “Bonds Rise as Factory Data Temper Inflation Angst”. That good factory data news was in reality US manufacturing output contracting more than expected. In fact, goods-producing employment was one of the first segments of the market to fall in 1989. 

Since we’re on this fool’s errand together, we’re led to believe that the market is in danger of a significant correction prior to the end of 2023. Potential catalysts we see on the horizon are declining financial leverage, rapidly declining M2 supply, resumption of student loan payments, and an unemployment time bomb. Despite significant layoffs, particularly in the tech sector, employment data remains strong. The large technology companies that have significantly cut staff often provide very generous severance packages. Those packages will begin to run out in the second half of this year. There is potential for a weakening employment picture, combined with the delay in unemployment filings from tech employees rapidly changing the investor sentiment. Do keep in mind that the yield curve is just one data point flashing a recessionary warning and it is the responsibility of each investor to analyze this in conjunction with other economic signals they may use.

A Bold Prediction

Sentiment may be that we have successfully engineered a soft landing and dodged a recession, and history would suggest that feeling may persist in the short term. The bull market trend will continue. However, by winter, Santa Claus will be bringing us coal rather than a rally. 

Currently the S&P 500 sits 15.7% higher than the beginning of the 10YR/2YR inversion. 11.7% of that appreciation occurred following the curve inversion bottoming. The latest market top on July 31st was a 19.8% gain from the inversion onset. This is tracking in-line with the expectations from past cycles. Going forward, we would expect, on average, a further ~3% gain in the S&P 500 through the back half of 2023. Around that same time we should be looking for the 10YR/3MO curve to have put in a bottom, which may have occurred this past May unless tested again. At that point, potentially Q4 2023, we expect to be entering a recession with the associated market declines at the end of cycles usually significant.

And a Bit of Optimism

While recessions can be difficult and disruptive, it's important to remember that they are a natural part of the business cycle and can actually have some positive long-term outcomes. For one, recessions help to weed out weaker businesses that cannot viably compete in the market, which allows for new, more innovative companies to grow into the gaps formed. This ultimately creates the next set of opportunities for investors like us which we will eagerly await down the road.

To that point, history has shown that some of the best companies of our time were founded during times of economic difficulty. The great recession birthed the gig economy platforms such as Uber and Airbnb. The dot com bust saw the formation of Google, Salesforce, and Akamai Technologies to name a few. And the 1981 recession gave rise to Costco and Compaq Computers. They serve as a reminder that recessions can be a breeding ground for creativity and innovation, as entrepreneurs are forced to develop new solutions to the challenges they face. So while recessions can certainly be challenging, they can also be a time of great opportunity and growth. By keeping a positive outlook, we can weather the storm and come out even stronger on the other side.

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