Inverted Yield Curve Signals a Recession. A Different Curve Tells a More Upbeat Story.

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The most-watched yield curve is close to inverting, a scary signal for the stock market. But there’s a less watched stretch of the yield curve that is a better indicator of future economic troubles.

The good news: This second curve is still a long way from inverting.

First, a primer. In a normal yield curve, short-term bonds have lower rates than long-term bonds. That’s because there’s more risk of inflation developing over a period of years, and investors demand a higher rate in return. When the yield curve inverts, short-term bonds have higher yields than long-term bonds. That frequently happens when the Federal Reserve is raising short-term rates to tame inflation, as it is now. An inverted curve signals that investors see the economy slowing down, causing long-term rates to slump.

Wall Street typically looks at the relationship between the 10-year Treasury note and the 2-year Treasury note. Right now, the 10-year yield is just 0.21 percentage points higher than the 2-year yield, down from a 1.17 percentage point differential six months ago.

Investors should watch out for “an inversion in the yield curve that would suggest… rising odds of a looming recession,” wrote Tom Essaye, founder of Sevens Report Research. 

Still, an inversion between 10-year and 2-year yields doesn’t necessarily mean mayhem for the economy and stock market is happening soon. It can take several years for a recession to happen after an inversion of the 10-year and 2-year Treasury yields, Morgan Stanley data show. An inversion happened in 2005, for instance, but the Great Recession didn’t begin until late 2007. Consistent with that, stocks usually perform just fine for the year after an initial inversion. The average move for the

S&P 500
for the 12 months after an initial inversion of the 2-year bond yields was a 7.4% gain, according to Dow Jones Market data that goes back to 1978.

Market analysts at 22VResearch say there’s a different stretch of the yield that is a far more telling indicator for the future economy and stock market. That is the difference between the 10-year Treasury note and the three-month Treasury bill. If investors are so pessimistic about long-term growth that they’ll take a lower return on a 10-year note than on a 3-month bill, that’s a particularly bad sign.

“Historically, 10s-3mos has been more reliable, particularly over the past few decades,” wrote Dennis Debusschere, the firm’s founder.

The average move in the S&P 500 for the 12 months after an initial inversion between the 10-year and 3-month yields is a 1.4% gain. The index has gone down half the time. “The 3M-10Y curve is a more useful tool at forecasting recession and weak stock markets,” wrote Gavin Stephens,  director of portfolio management at Goelzer Investment Management. 

Right now, stock investors have the all-clear signal from that yield curve. The 10 year Treasury note currently yields 1.87 percentage points more than the 3-month bill.  

Bottom line: While there is certainly cause for concern, it’s not time to panic yet. 

Write to Jacob Sonenshine at [email protected]