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Yield curve inversion and the equity market

Bad omen: what the yield curve says about stocks

August 2019

Luca Paolini, Chief Strategist

The inversion of the US yield curve strengthens the bear case for the economy and stock markets.

A US recession and flat equity markets. If history is any guide, that is what the inverted US yield curve is forecasting.

Yields on benchmark 10-year Treasury bonds have this month fallen below those on 2-year paper for the first time since 2008. That follows an inversion of another part of the curve earlier in the year. The trend isn’t limited to the US either – UK and Swiss curves are also inverted, while Japan is a whisker away (see chart).

turning negative
Yield spread between 10-year and 2-year government bonds, ppts
yield spread in major economies
Source: Refintiv. Data covering period 01.08.2018-14.08.2019.
According to our research, that means storm clouds are gathering both for the economy and for equity markets. 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.
A US recession typically occurs 1 year after the inversion of the yield curve between 10 and 2 year bonds. That’s because the yield curve has historically been very closely correlated with the output gap – the difference between an economy's current rate of growth and its long-term potential (see chart).
lessons from history
Yield spread between 10-year and 2-year Treasury bonds and US output gap, ppts
US output gap and yield spread
Source: Refinitiv. Data covering period 14.08.1986-14.08.2024.

If precedent holds, US economic growth is set to decelerate significantly – according to our analysis the curve implies an average real GDP growth of about 1 per cent over the next five years. That average, in turn, likely hides a period of economic contraction.

All of which is bad news for equity markets. Every bull market has started and ended with a US recovery and a US recession since 1950 – and we’ve had 10 recessions since then. This suggests that a major market peak is likely within the next 12 months.

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 the 10-year and 2-year US bond yields indicates US equities could deliver as little as 2 per cent per year over the next five years in nominal terms. That's only marginally below the forecasts in our Secular Outlook and down from an annualised return of about 10 per cent during the previous five years. Factor in inflation, and real returns will be around zero.

In other words, the US yield curve is telling us that the S&P 500 in 5 years’ time will be around 3,000, almost unchanged from current levels. This doesn’t mean the market will flat-line over the whole period. Instead, there’s likely to be considerable volatility – another typical consequence of an inverted yield curve.

An inverted yield curve is consistent with the VIX index – a measure of expected volatility of US equities, based on options pricing – to rise around 30 per cent over the next two years.

What does this mean for investors? Strategically, this is the right time to reduce allocation to equities. Tactically, the market could offer a final “entry point” in this cycle, but the upside is limited in both time and size.