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Yield curve inversion and the equity market

Not looking great: what the yield curve says about stocks

March 2019

Luca Paolini, Chief Strategist

An inverted yield curve is a bad omen for the economy and stock markets. 

Will the yield curve get it right once again?

With 10-year US Treasuries yielding less than short-term bills for the first time since 2007,* investors may be hoping not. 

That's because an inverted (or flattening) yield curve has historically proved a reliable predictor of recessions and bear markets in stocks. In the US, for instance, each of the last seven slumps has been preceded by an inversion of the curve.

Even though a sharp downturn doesn’t look imminent, investors shouldn’t wait too long before bolstering their defences.

To understand why, it’s useful to take a closer look at what an inverted yield curve actually shows.

If history is any guide, the US is on course to experience a recession within the next 18-24 months.

We see the yield curve as a proxy for a country's output gap - or the difference between an economy's current rate of growth and its long-term potential. Seen from this perspective, any flattening or inversion of the curve suggests the economy is closer to hitting its speed limit, at which point it will quickly begin to decelerate.

The curve's recent move into negative territory points to an economy that's entering the last phase of an expansion that began back in 2009; so if history is any guide, the US is on course to experience a recession within the next 18-24 months, reducing its yearly economic growth rate over the next five years to an inflation-adjusted 0.5 per cent. 

This, in turn, would weigh on equity market returns over the medium to long run.

Although the yield curve is just one of a number of variables we use in our asset class return forecast model, the negative spread between 3-month and 10-year US bond yields indicates US equities could deliver as little as 1 per cent per year over the next five years. That's down from an annualised return of 11 per cent during the previous five. 

An inverted curve has in the past been a bad omen for the economy and equity markets. There's no reason to believe this time will be any different.