The Yield Curve

By Reed C. Fraasa, CFP®, AIF®, RLP®

This past week we experienced a 4.6% decline in the US stock market. Foreign stocks fared better with a 2.06% decline. With the US market is down over 10% since late September, about half of the recent loss occurred just last week.

The cause of last week’s sudden sell off was fear of a recession as a result of the yield curve suddenly flattening. The yield curve is a comparison of short-term rates to long-term rates. Generally, an upward sloping yield curve (sloping from San Diego, CA up to Portland, MA) is a good sign of a healthy economy. The 10-year bond vs 3-month bond is a good benchmark for the yield curve and that suddenly flattened out.

Specifically, on 12/3/18 the 10-year yield was 2.98% vs the 3-month yield at 2.38%, or a spread of 60 basis points. The next day the 10-year yield was 2.91% vs the 3-month yield at 2.42%, or a spread of 49 basis points. This trend continued until last Friday when the spread was 45 basis points. It is the lowest level in 11 years.

News of this was received like a herd of gazelles spotting a lion in the grass. Traders started selling. (Read next week’s article to learn more about why I think this behavior happens and why it may continue)

The yield curve is important to monitor because it may be a sign that we are heading into an inverted yield curve (long-term rates lower than short-term rates), which is always associated with a recession. An investor expects to be rewarded for buying longer-term bonds by receiving a higher yield. A flattening yield curve may indicate that the economy is weakening. It is a sign that markets expect little economic growth and that banks may tighten their lending practices. However, not all flattening yield curves result in recessions. Important information to monitor, but not absolutely predictive of the future.

Like a herd of gazelle, last week very few investors stopped to rationalize the situation. In fact, stock market returns following periods where the yield curve reached spreads below 50 basis points have actually been better than average. Since 1962, the 10-year and 3-month yield curve has dipped below 50 basis points nine times. With the average duration before the start of a recession being two years, recessions rarely immediately followed a compressed yield curve. Only one occurrence (11/30/73) did a recession start within one year.

The chart below illustrates each occurrence (red dot) and the time from a recession (grey bar). Note that in the late 1990s three occurrences happened before a recession.

Source: Bespoke Investment Group, LLC

Source: Bespoke Investment Group, LLC

Furthermore, market performance following periods when the yield curve first dipped below 50 basis points has been better than average. While the average duration from a dip below 50 basis points to a recession is two years and the median has been 1.5 years, the following one-year returns in the S&P 500 have been 9.03% and 10.21%, respectively. The chart below illustrates each of the prior eight time periods since 1962.

Source: Bespoke Investment Group, LLC

Source: Bespoke Investment Group, LLC

Like all the economic indicators, the yield curve is certainly important to monitor. However, selling prematurely based on the hint of an economic trend is imprudent. History tells us the patient, steady investor is rewarded for not panicking.

Next week I’ll address a question we have been asked a lot recently. If most of the stock market is managed by professionals, why does it become so volatile at times and then settle out and return to normal values.