The US yield curve just inverted! For the average American, they have little idea of what that means. It’s often seen as a bad omen. Normally, longer term bonds have a higher yield than shorter term bonds (i.e. A “normal” yield curve). When the yield difference between long and short term bonds reverses (short term bonds have a higher yield than long term bonds), we end up with an “inverted” yield curve.
Why does this matter? Well, an inverted yield curve often precedes a contraction in the economy (i.e. recession). In fact, the yield curve has become inverted before each of the last 7 recessions in the U.S.
So, how should we invest in light of the inverted yield curve? Well, the chart below shows us the 3 year stock market performance (after a yield curve inversion) in 5 major developed nations over the last 33 years (since 1985).
In 10 out of 14 cases of inversion, local investors would have had positive returns investing in their home markets after 36 months. This is not much less than the historical experience of these markets over the same time frame, regardless of the shape of the yield curve. These results show that it is difficult to predict the timing and direction of equity market moves following a yield curve inversion.
So, in summary, if you hear the media freaking out about the inverted yield curve, tune out the noise. Long term investors should look beyond short term movements in the stock and bond markets.
Exhibit 1. Stock Market Performance in Selected Developed Countries Following a Yield Curve Inversion
Yield curve inversions based on 2-year and 10-year government bond yields for each country. Yields obtained from Reserve Bank of Australia, Bundesbank, Japanese Ministry of Finance, Bank of England, European Central Bank, and US Federal Reserve. Stock returns based on local currency MSCI indices. MSCI Australia Index (gross div., AUD), MSCI Germany Index (gross div., EUR), MSCI Japan Index (gross div., JPY), MSCI United Kingdom Index (gross div., GBP), MSCI USA Index (gross div., USD.) These countries were selected to represent the world’s major developed country currencies. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. MSCI data © MSCI 2018, all rights reserved. Past performance is no guarantee of future results.
. The data showed a 71% chance (10 of 14) of a three-year positive return following a yield curve inversion. To compare, we measured returns three years following every month-end between January 1985 and December 2014 in each of the five markets based on the local currency MSCI indices. The average chance of a three-year positive return in those five markets was 77%.