Why an Inverted Yield Curve Is Bullish For Stocks

The yield curve briefly inverted on Wednesday when the yield on the 10-Year U.S. Treasury Note dipped below that on the 2-Year T-Note for the first time since 2007. Given that an inverted yield curve historically signals an upcoming recession, and given that recessions can trigger or deepen bear markets, nervous equity investors launched a selling frenzy, sending the S&P 500 Index (SPX) down by 2.9% for the day.

Significance For Investors: Bullish In Short Term

But the outlook, actually, may be more bullish than bearish for stocks in the short term, according to a detailed story in The Wall Street Journal. Based on history from 1978 to 2005, after the yield curve first inverted, the S&P 500 advanced by an average of 2.53% over the next three months, by 4.87% over the next six months, by 13.48% over the next year, by 14.73% over the next two years, and by 16.41% over the next three years, per analysis by Dow Jones Market Data cited by the Journal. As a result, JPMorgan, Goldman Sachs, and other firms are advising their clients to expect a rebound in stock prices.

Key Takeaways

  • An inverted yield curve historically signals an upcoming recession.
  • Stocks fell after a brief inversion on Aug. 14.
  • However, history indicates that more stock gains may be ahead.

“People believe that [a yield curve inversion] is going to cause a recession, that it’s only a matter of time. And in fact, what we find is that it takes quite a long time,” as Mariann Montagne, a fund manager at Gradient Investments, which has $2.3 billion in assets under management (AUM), told Bloomberg. “We have a lot of money to make between now and then,” she added.

James Bullard, president of the Federal Reserve Bank of St. Louis, is among those who discount recessionary fears. He calls U.S. economic conditions “quite good,” and in a recorded commentary posted on the St. Louis Fed’s website on Aug. 14, he said this, as quoted in another Bloomberg report: "The economy’s not in recession. Unemployment is near a 50-year low. Inflation is low and stable." 

 A week ago, JPMorgan advised clients to use index options to profit from an expected rebound in the S&P 500, based on their 3,200 year-end 2019 price target, per Bloomberg. This would represent a 12.9% gain from a morning low during trading on Aug. 15. Meanwhile, on Monday, strategists at Goldman Sachs issued an optimistic recommendation of their own, saying that relatively low implied volatility has made stock prices attractive, per the same report.

At the close of trading on Aug. 14 the yield on the10-Year T-Note closed fractionally above that on the 2-Year T-Note, 1.59% versus 1.58%, per the U.S. Department of the Treasury.

Looking Ahead

After studying the 10 previous inversions since 1956 between the rates on the 10-Year T-Note and the 2-Year T-Note, Bank of America finds that each preceded a recession, but with lags that can be long, per Bloomberg. Their study also indicates that investors betting on a post-inversion recovery in stock prices need to be patient. After 6 of those 10 inversions, the S&P 500 was down over the next 3 months, and in the other 4 it did not top out until at least 11 months later.

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