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Is the yield curve signalling a downturn?

Updated: Sep 3, 2019

One of the most reliable recession indicators is the yield curve, which compares bonds’ short-term and long-term interest rates. Most of the time, long-term rates are higher than shorter-term rates. This rewards lenders for taking a bigger risk by loaning their money for a longer period of time.

But today, the yield curve inverted; long-term bonds' interest rates fell below short-term bonds' interest rates. Specifically, the 10-year Treasury yield fell below the 2-year yield.

This occurred before all nine U.S. recession since 1955, with only one false signal, according to the Federal Reserve Bank of San Francisco. Even then, the inversion predicted a significant slowdown. They found that on average, recessions occurred 6 - 24 months after inversions. Researchers Bernard and Gerlach (1996) found that the yield curve inversions also reliably predict recessions for countries around the world.

Don’t bet against stocks rising just because the yield curve inverts. LPL Research found that since 1978, the S&P 500 rises an average 21% after the yield curve inverts before finally peaking. And Dow Jones Market Data shows that after the yield curve inverts, the S&P 500 often gains 13.5% after a year, 14.7% after two, and 16.4% after three.

The utilities and consumer staples sectors have had positive 6-month performance after all three yield curve inversions after 1980, according to CNBC. Utilities returned an average 8.59%, while consumer stables only returned an average 2.67%.

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