The flattening of the yield has been worrying some Wall Street watchers, who see it as a sign that the economy is heading south. But while the yield curve is an important economic indicator, the flattening isn't a reason for stock investors to panic. That's according to Charles Schwab chief investment strategist Liz Ann Sonders, who said that, while there are reasons for investors to be cautious about stocks, the potential for an inversion of the yield curve "is not one of them."
The yield curve, which is a snapshot of the expected rate of returns on a collection of bonds with different maturities, can tell a lot about the perception of the economy based on its curve. After all, its record as an indicator has been consistent, with The Charles Schwab Corporation (SCHW) pointing out that every recession in the U.S. and accompanying global economic recession over the past 50 years was preceded by an inverted yield curve.
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Currently, the yield curve, which is the difference between the yield on the two-year Treasury and 10-year Treasury, has been flattening to less than 50 basis points, hitting a low of 41 basis points at the end of April. While Sonders said that the gap has widened, it is close enough to 50 basis points to lead to some worries, but investors should not panic. Going back to the 1970s, there were only five cases when the gap between the two-year Treasury and the 10-year Treasury fell below 50 basis points, noted Sonders. In those cases, it took close to three years on average for the recession to arrive.
Looking at the yield curve from the point at which it actually inverted, Sonders found that a recession didn't appear until almost two years later on average. In those five instances, stocks continued to have positive returns as the yield curve flattened and then inverted. "Of course, equity bear markets tend to begin in advance of recessions, which is perhaps why investors are getting nervous about the curves flattening," Sonders said in a report. "Inverted curves have tended to lead bear markets, but often with a substantial lag. But not all bear markets were preceded by inverted curves. That's why only looking at the yield curve doesn't yield strong conclusions across all market environments."
With a strong showing out of corporate earnings for the first quarter and other positive economic data, Sonders said that growth in the economy is continuing at a steady pace. Still, she said that investors do have to be more disciplined and patient in the current environment. "The next few months could continue to be choppy, but a U.S. and/or global recession still appears a ways off, which should keep the bull market – here and globally – intact," the strategist said.