Yield curve inversion, recession risk and equity returns

There is increasing concern about the flattening of the US yield curve. Rising government bond yields, high commodity prices and geopolitical tensions risk pulling the economy into recession. However, the New York Fed’s estimates of recession probabilities over the next 12 months have continued to decline in recent months (see Chart 1).

Chart 1. US recession probability seems low

Source: New York Fed and Refinitiv. Data as at 11.04.2022.

This reflects the increased yield spread between 10-year government bonds and 3-month bills, the Federal Reserve’s preferred measure of the yield curve slope for forecasting recessions.¹ The increase in the 10Y-3m spread contrasts with the flattening of the 10-2Y spread, which recently and briefly turned negative (see Chart 2).

Chart 2. US yield curve slope and US recessions

Source: New York Fed and Refinitiv. Data as at 11.04.2022.

Many commentators see the 10-2Y yield curve inversion as a harbinger of impending economic recession and a bad omen for future investment returns. To shed light on the leading power of the 10-2Y bond yield inversion on the economy and markets it is useful to look at the historical evidence (see Table 1 and 2 as well as the Appendix).

Table 1. Average lead of curve inversion before first negative GDP qoq change

Table 2. Average returns and frequency of negative returns

Source: Refinitiv and EFGAM calculations. Data as at 11.04.2022.

In the period since World War II, the 10-2Y spread has inverted 11 times excluding the current episode. On average, it preceded a quarterly contraction of American GDP by six quarters and, if we consider only the period since 1988, the lead-time rises to eight quarters.

In the twelve months following these 11 instances of yield curve inversion, the S&P500 index of US equities rose two-thirds of the time. In the period since 1988, realised equity returns have exceeded the full sample average returns in the first three months after the curve inversions and on a 12-month horizon.

Furthermore, in the most period since 1988, the stock market has always outperformed US long-term government bonds in the first three months after the curve inversion and in three out of four occasions over a six-to-twelve-month horizon. However, on longer horizons equity market outperformance over government bonds was less pronounced than in the full sample.

To conclude, if what happened over the last 35 years is a reliable guide to the future, the recent inversion of the US 10-2Y yield spread does not necessarily signal an imminent recession. Furthermore, historical evidence shows that equity markets have often performed well in the 12 months after a yield curve inversion. Every situation is different and it is certainly worth taking note of recent yield curve behaviour as it signals a heightened degree of risk to the economy. However, the statistical evidence indicates that the recession signal would become much stronger should the 10Y-3M part of the curve invert.

Appendix. Detailed GDP and market performances after each inversion

¹ See «Information in the Yield Curve about Future Recessions», Michael D. Bauer and Thomas M. Mertens, Federal Reserve Bank of San Francisco Economic Letter, 2018, http://go.pardot.com/e/931253/-uploads-sites-4-el2018-20-pdf/jvz6/43751963?h=ekxRKmPu93i32LH-RCMMTZgWeP8t63UlPLrFuAT7J-c