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July 30, 2018
No, this isn’t some newfangled common core math test! My daughter is 7 years old and, despite her parents’ mathematical abilities, she struggles with math. Addition makes sense, but subtraction is a challenge. 2+2 is most definitely 4 but 4-2 isn’t as clear cut. It reminds me of the accounting joke, “what’s 2+2?” “Whatever you want it to be.” So, at this point you may be wondering why 10 – 2 = 0.28.
The yield curve is a graphical representation of the different yields available on a particular security, usually Treasuries, at different maturity dates. Below you can see the yield curves from the first trading day of each year from 2010 through 2018, plus the most recent day (7/19/2018).
The chart shows in January of 2010, the lightest grey line on the chart, 1-month Treasuries yielded about 0% while 30-year Treasuries yielded just over 4.5%. Today, the 1-month Treasury is just below 2% and the 30-year is at about 3%.
The more common measure of the yield-curve spread is known as the 10-2 spread—the 10-year Treasury constant maturity minus 2-year Treasury constant maturity. Currently that value is about 0.28%. The historical spread is shown in the chart below from the Federal Reserve (Note: gray bars are U.S. recessions) along with a few of my notes explained later.
Historically, as you can see in the chart above, when the yield curve begins to “invert”—when long-term rates are lower than short-term rates—a U.S. recession has followed. Market commentators on TV, blogs, magazines, and radio have been harping about the yield curve for a while now as it creeps closer and closer to inversion.
Chinn and Kucko have written working paper called The Predictive Power of the Yield Curve Across Countries and Time for the National Bureau of Economic Research.[i] In this paper they delve into the yield curves of several countries from the 1970s through the 2000s (the paper was written in 2010). While the inversion of the yield curve has historically pointed to an oncoming recession, the predictive power in the United States has faded over time.
In their own words, “The yield curve clearly possesses some forecasting power. However, there is also some evidence the United States is something of an outlier, in terms of its usefulness for this purpose. And overall, the predictive power of the yield curve seems, with some notable exceptions, to be declining over time.”
What the Future (Historically) Holds
There is always good news and bad news… and people who will say “this time is different.” Historically, the lag time between yield curve inversion and a recession varies between 13 months and about 2 years (see “Lag Time” in chart above). S&P 500 stock returns during the “waiting period” are generally pretty good.
The August 1978 inversion posted a -0.78% return for the next year, September 1980 was 6.63%, December 1988 was 27.15%, February 2000 was -2.62%, and December 2005 was 4.22%. Returns of the S&P 500 from the start of the inversion to the start of the recession were actually very good in all cases except 2000, averaging 15.7%.[ii]
In other words, the yield curve may signal that a recession is on the horizon but not when it will occur, and getting conservative too early can be costly.
If you pay attention to the financial media, you have likely heard about the yield curve nearing inversion and historically that points toward recession. While the most common measure of inversion, the 10-2 spread, is still positive, it has gotten low. Through the 1990s we saw similarly low spreads before dipping negative in 2000. No matter how it is spun, this indicator does NOT spell imminent doom to your portfolio or the economy. It is simply one more measure to keep in mind while reviewing all the economic data coming out.
As always, if you have any questions about this or any other matter, please feel free to contact your financial advisor.
[ii] Return calculations are performed using adjusted close pricing data from Yahoo! Finance
Bryan Strike, MS, MTx, CFP®, CFA, CPA, PFS, CIPM is a Senior Financial Advisor at Kays Financial Advisory Corporation. He can be reached at (770) 951-9001 or at email@example.com.
This report and Mr. Strikes’ comments are provided as a general market overview and should not be considered investment or tax advice or predictive of any future market performance.
Any security mentioned in this report may not be suitable for all investors. No investment mentioned in this newsletter constitutes a recommendation to buy, sell or hold a particular investment. Such recommendations can only be made on an individual basis after an assessment of an individual investor’s risk tolerance and personal circumstances. Past performance of any investment mentioned is not a guarantee of future performance. Statements regarding the investment concerns and merits of any investment and fair market value computations are strictly the opinion of Kays Financial Advisory Corporation. Employees of KFAC and KFAC clients may have positions and effect transactions in the securities of the issuers mentioned here in.