What happens to returns when the yield curve inverts?

Those worried about a recession often monitor the yield curve for inversion, particularly the spread between U.S. two- and 10-year Treasurys. But instead of worrying, investors might want to consider an analysis of additional spreads.

After analyzing 10 yield spreads along the Treasury curve, AGF finds that S&P 500 returns remained positive, on average, in the year leading into an inversion as well as in the following year—though the index’s performance weakens the closer in time to the inversion date.

Based on the data, “some investors may be overestimating the potential negative impact that an inverted yield curve can have on stock market returns,” says Stephen Duench, vice-president and portfolio manager at Highstreet Asset Management Inc., in an AGF blogpost.

Inverted spreads coinciding with the worst returns tended to involve the three-month Treasury and longer maturities. After inversion of the three-month and 10-year, for example, the average three-month forward return profile was 0.52%.

In contrast, inversion of the two- and five-year yields corresponded to “some of the better intermediate returns found in our research,” Duench says in the post. For example, the average three-month forward return was 1.42%; the average six-month forward return, 3.22%. He also notes that the “recession-whispering” two- and 10-year inversion generally occurred without resulting in the worst returns.

Another finding was that return profiles were better when fewer spreads along the yield curve inverted. But even several inversions resulted in relatively tame negative returns. For example, with eight inversions, the average three-month forward return was −0.69%.

While past performance can’t predict future performance, the data “provide important perspective at a time of growing economic uncertainty and increasingly volatile markets,” Duench says.

Despite increased volatility, BlackRock says in recent fixed-income commentary that it doesn’t forecast a recession this year, though the risk increases with oil sector woes, as well as rising rates and lower consumer spending.

However, “it is no longer a certainty that rates will take off,” the BlackRock commentary says. “With the yield curve as flat as it is, there could be opportunity on the short end—at least for investors who are not in the recession-is-around-the-corner camp.”

For those investors, BlackRock suggests considering a tactic of reducing duration and taking on more spread risk.

Read the full BlackRock report.

For full details on various inversions and yields, see the AGF blogpost.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.