Inverted Yield Curve Is No Death Sentence for Stock Market

(Bloomberg) -- The hand wringing among stock investors over an inverted yield curve is overblown, if history is any guide.

So says Canaccord Genuity's strategist Tony Dwyer, who has studied equity-market performance after the payout of long-term Treasuries fell below that of short-dated government debt. Such inversions have occurred seven times since the early 1950s and all but one preceded equity gains. Specifically, the S&P 500 Index rose a median 19 months before peaking after an inversion, with returns reaching 21 percent.

The analysis is perhaps a wake-up call for many who sold equities this week after the difference in yields on 3- and 5-year notes dropped below zero for the first time since 2007. The negative showing was one culprit blamed for the S&P 500's 3.2 percent plunge Tuesday as bears pointed to the bond market as flashing an ominous signal on the economy.

More importantly, according to Dwyer, the more commonly followed 2- to 10-year yield spread, which the firm monitors as a potential indicator of pending recessions, is still positive, albeit at 12 basis points, close to the smallest since 2007. The S&P 500 has proved to be able to shrug off most initial inversions because continued economic expansions, even at a slower pace, bode well for stocks.

“I'm not saying it's not going to be a recession. I'm not saying it's different this time. I'm saying it's the same,” Dwyer said by phone. “You're going into a recession, but it typically happens well after, with stocks much higher from the initial date of inversion,” he said. “History says you don't want to be a seller here. You want to be a seller higher.”

Click here for a QuickTake on the yield curve

Dwyer's warning was echoed by at least two strategists Thursday, as the S&P 500 extended this week's sell-off. Credit Suisse's Jonathan Golub said a flatter curve doesn't represent “an imminent problem.” Tom Lee, the co-founder of Fundstrat Global Advisors LLC, said it'd be a mistake to pay too much attention to the 3- to 5-year yield inversion, as that pattern has occurred 73 times since 1954 while the economy endured only nine recessions.

“5Y-3Y inversion predicted 73 of the last 9 recessions, too many false positives,” Lee wrote in a note to clients.

While fears over an inverted yield curve may be overdone, the heated discussion of the topic reflected two pressing issues that are gripping the market: slowing growth and higher interest rates. And it's not hard to see why investors got so hung up on negative narratives with the bull market in stocks approaching its 10th anniversary.

Investors can be forgiven for taking caution against a worst-case scenario now that strategists at firms including Goldman Sachs and Bank of America have recommended raising cash in anticipation of a lackluster 2019. A potential inverted yield curve is likely to lead to a mild bear market next year, BofA strategists Mary Ann Bartels and Andrew Shields wrote in a note this week.

Still, others say worries over an inversion are premature as economic data from manufacturing to initial jobless claims has shown solid growth. While economists see the economy losing some steam over the next two years, the median estimate calls for a 2.6 increase in gross domestic product in 2019. And odds the U.S. will fall into a recession in the next year stands at 15 percent, according to Bloomberg's U.S. Recession Probability Forecast index.

Even after an inversion, it usually takes about 19 months for a recession to hit the economy, data compiled by Canaccord showed.

“They're leading indicators, not coincidental indicators,” Scott Colyer, chief executive officer at Advisors Asset Management Inc., said on Bloomberg TV. “The Fed has a habit of going one or two interest rate increase too far” before it reverses course to cause an inverted yield curve, he said. “Are we at that point? The answer is probably no. Are we at a point where risk assets should begin to underperform? We're not there either.”

To contact the reporter on this story: Lu Wang in New York at lwang8@bloomberg.net

To contact the editors responsible for this story: Courtney Dentch at cdentch1@bloomberg.net, ;Jeremy Herron at jherron8@bloomberg.net, Dave Liedtka, Mark Tannenbaum

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