What Does an Inverted Yield Curve Tell Us?

Last month, the 10-year Treasury yield fell below the 3-month yield for the first time since 2007, signaling a yield curve inversion.

Legend has it inversions are bad news—inverted yield curves have preceded each of the last seven recessions.

Should we be worried?

Inversions and Recessions

Historically, the U.S. Treasury yield curve—a snapshot of how yields vary across bonds of similar credit quality at different points in time—has been upward sloping.

When it begins to invert, as it did in March, investors worry that the economy is weakening, equity markets will decline, and a recession may be on the horizon.

History corroborates this concern—recessions have followed yield curve inversions within an average of 16 months and have lasted about 12 months.

Given this, investors might be tempted to time the market—getting out of stocks after an inversion and getting back in later.

But can we accurately predict the timing and direction of equity market moves following a yield curve inversion?

Inversions and Market Timing

To answer this, researchers at Dimensional Fund Advisors (DFA) examined stock returns following inversions for five major developed nations, including the U.S., since 1985.

In the U.S., returns were higher 66% of the time 12 months after an inversion and 33% of the time 36 months later.

But the paucity of U.S. inversions provides a data set so small it’s challenging to draw strong conclusions about the relationship between the curve and stock market returns.

When DFA factored in comparable data from other developed countries—Australia, Germany, Japan, and the UK—returns were higher 86% of the time 12 months after an inversion and 71% of the time 36 months later.

While an inverted yield curve may be an indicator a recession is coming, it is not a reliable indicator to profitably time stock markets.

And while stock market returns have been lower than their historical average following periods of inversion, returns have still been positive—both domestically and abroad.

The Real Danger in the Curve

A recession is certainly possible following periods of inversion.

But market downturns are always possible. The real danger in a downward curve comes when investors panic during down markets, pulling money out or delaying plans to invest more just when they should remain invested.

When the yield curve turns down, it’s best to stick to a well-thought-out plan that already incorporates inevitable downturns and provides the best chance for meeting long-term goals.