The latest thinking from Greenspring Advisors.

Who’s Afraid Of An Inverted Yield Curve?

J. Patrick Collins Jr., CFP®, EA

Equity markets experienced more volatility over the past week with much of it coming over fears of an inverted yield curve.  The yield curve is simply what bonds yield at various maturities.  In a normal environment, investors would expect to earn higher yields on longer-term bonds.  You have to lock up your money for a longer period and you take on more inflation risk, so investors expect to be compensated with higher yields.  When a yield curve inverts, it just means that shorter maturity bonds are yielding more than longer maturity bonds.   Historically, the yield curve inverts because sentiment suggests that the long-term outlook is poor and the yields offered by long-term bonds will continue to fall.  Articles like this show why investors may be spooked.

Inverted yield curves often forecast recessions, but do they forecast stock returns?  Should investors consider lightening up on (or getting out of) stocks because of this inversion?  Nobel Prize Laureate, Gene Fama and Ken French explored this very topic in their paper, Inverted Yield Curves and Expected Stock Returns.

The study looked to see if there was any value in moving into treasury bills (from stocks) after the yield curve inverted.  If this inversion was predictive of falling stock prices, you would expect to see this strategy outperform the stock market.  In fact this is not the case.  When 2 year bonds yield more than 10 year bonds (typical measurement for yield curve inversion), the strategy of moving to treasury bills underperforms the stock market by approximately 1-2% per year over 1, 2, 3, and 5 year periods after the inversion.  This is a highly technical paper, but the summary is probably best stated with this sentence, “We find no evidence that inverted yield curves predict stocks will underperform Treasury bills for forecast periods of one, two, three and five years.”

As we’ve stated in the past.  It is very hard to find events or data points to predict short-term movement in the stock market.  In most cases, the best strategy is to maintain your strategy through both the good and bad events that will inevitably happen.