The Last Time the Yield Curve Inverted, Stocks Soared 30%

John Mauldin  |

Everybody is suddenly talking about the inverted yield curve.

They’re right to do so, too, but alarm bells may be premature. Inversion is a historically reliable but early recession indicator. Even a fully inverted yield curve—which is not yet—isn’t saying recession is imminent.

What we see now is really more of a flattened yield curve. It has a smaller but still positive spread between short-term and long-term interest rates.

That’s not normal, but it’s also not a recession guarantee. However, when we combine this with other threats, it adds to the concerns.

I’ve been writing in Thoughts from the Frontline about negative yield curve since 2000. Back then the inverted yield curve predicted a recession and I called a bear market in equities.

Ditto for 2006. That time the yield curve inverted long before the stock market turned, though.

Let’s look at what the yield curve is really telling us this time.

An Inverted Yield Curve Is Just a Fever

I’ve been using an analogy in my speeches recently that has received excellent feedback, so I want to share it with you.

Many media sources and writers seem to indicate that an inverted yield curve causes recession. That is simply not true.

Think of an inverted yield curve as a fever. When your body gets a fever, the fever is not the cause of the sickness. It just says something’s wrong with your body. You have the flu, appendicitis, or some other ailment.

The fever indicates you are sick but not necessarily what the sickness is. And typically, the higher the fever the more serious the condition.

It is the same with the yield curve. The more inverted the yield curve is and the longer it stays that way, the more chances something is economically wrong. Which may later show up as a recession.

A true inversion last happened in 2005. Were we in recession then? No, not at all. The economy was booming.

In fact, the yield curve stayed inverted until mid-2007. Some of us saw cracks forming in the economy, and said so at the time. But the actual recession would not begin until December 2007.

That’s a longstanding pattern. The inverted yield curve has been a pretty reliable recession indicator but it shows up far in advance—months or even more than a year. We might better think of it as signaling the cycle’s “blowout” stage. People see the inversion, observe nothing bad happening, then throw caution to the wind.

Recession Probability Based on the Spread

This idea that an inverted yield curve signals recession isn’t new. Nor did it appear from thin air.

In 1996, New York Fed economists Arturo Estrella and Frederic S. Mishkin authored a paper that compared the yield curve to 19 other indicators.

To summarize, Estrella and Mishkin found the yield curve is most predictive of recession a year or so ahead of time. In fact, they concluded an inverted yield curve was the only useful predictor of recessions.

Examining all the data from 1960-1995, they calculated the probability a recession would occur four quarters ahead, based on the spread between three-month and 10-year Treasury securities. They summarized it in the table you can find here (page 2).

Estrella and Mishkin found recession probability begins rising as the spread drops toward and then below zero. But it takes a long time. Even when the curve mildly inverts with the spread at -0.17%, the odds of a recession in the next year are still only 30%.

But from a practical standpoint, by the time their model shows a 30 or 40% probability of recession, there has always been a recession following that point.

What the Yield Curve Is Telling Us This Time

The 3M/10Y spread is now about 0.48%.

The study suggests this is consistent with about a 15% recession probability four quarters from now. Not so bad, if you are a bull. It means odds are good we’ll get through 2019 without recession.

Maybe longer, if the Fed pauses tightening next year and long-term yields stay where they are. We are not out of the woods, though. We may just be entering them.

On the other hand, history never repeats itself quite so perfectly. Other things are different—all the European Threats I described last week, or the prospect of wider trade war as President Trump tries to make China change its ways.

I would not conclude from the yield curve that recession is either imminent or impossible. It says what I already knew: A recession will strike at some point, but we probably have a little time.

Also note that market corrections, even serious ones, don't always happen in a recession. That could be the case this time with more than half of S&P 500 stocks already in a bear market.

And we haven’t even got a widely expected Santa Claus rally.

The current sell-off tells us that valuations are way too high and markets are way too nervous. If we do get an inverted yield curve and a recession on top, this bear market could be even worse than the last two—which were down 50%.

I have been telling everyone to be hedged and have a systematic way to control their downside risk for at least one year. Prepare to exit positions that may become illiquid, think of ways to hedge, and generally get ready for a volatile 2019.

Think of cash as an option in the future.

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Sharp macroeconomic analysis, big market calls, and shrewd predictions are all in a week’s work for visionary thinker and acclaimed financial expert John Mauldin. Since 2001, investors have turned to his Thoughts from the Frontline to be informed about what’s really going on in the economy. Join hundreds of thousands of readers, and get it free in your inbox every week.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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