The Risk To The Stock Market From An Inverted Yield Curve

If the U.S. yield curve inverts in 2022, it may signal that a recession is coming and that can mean poor returns for stocks. Currently, the U.S. yield curve still has an upward slope to it, but it is flattening in places, largely because government bond yields between 3 months and 5 years out have risen meaningfully, while the yield on the 10 year and longer durations have risen at a slower rate. This is, in part, because many see the Fed raising rates in 2022. The result is a generally flatter yield curve, which could mean that inversion is coming.

Research On Yield Curve Inversion

The ability of the U.S. yield curve to predict recessions is reasonably well studied by academics. This paper find that the term spread, or the difference between 3-month and 10-year U.S. Treasury yields has historically been predictive of future U.S. economic growth.

Hence, even if the yield curve does not invert, maybe the current flattening is a sign that slower growth may be on the horizon.

A Recession Predictor

Perhaps even more powerfully, this paper shows that the U.S. yield curve inverting has predicted all but one of recent U.S. recessions since the 1970s, and without any obvious false positives. The exception was the recession of 1990, though the yield curve was still relatively flat before the recession. The model appears to work for many countries beyond the U.S. too, with varying degrees of accuracy.

Important Caveats

There are however, some important caveats. The first is perhaps that the slope of the yield curve is now a very well-monitored indicator. That may reduce its forecasting power. For example if the Fed is basing some of its predictions, and indeed policy actions, off the shape of the yield curve, then the metric may start to change economic policy in ways it didn’t in the past.

Second, timing is an issue. The yield curve may invert before a recession, but a recession is seldom immediate. Knowing a recession is coming is useful, but the stock market can rally in the period between the signal and the recession, should it occur. Furthermore, the stock market is complex and may rally even as a recession hits, if that recession is baked into analysts’ forecasts.

As a result, just because we know a recession is coming, doesn’t mean that the stock market is guaranteed to do poorly. However, with the current U.S. stock market still relatively elevated in historical valuation terms, there are reasons to be cautious.

Thirdly, there are some implementation nuances, exactly how you choose to measure the shape of the yield curve and how deep of an inversion is up for debate and there is divergence on the exact process that should be followed.

So there are reasons to keep an eye on the yield curve in 2022, and to watch out for potential inversion. However, predicting a coming recession, though not easy, may be easier than predicting the direction of the stock market.