Of all the indicators analysts watch to gauge where we are in the economic and market cycle, the bond market ̶ and specifically the shape of the U.S. Treasury yield curve ̶ gets it right more often than any other. The Federal Reserve Bank of San Francisco recently noted, "Every recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve."
For those of you scoring at home, the spread between the 10-year and the 1-year U.S. Treasury rate at the beginning of 2017 was 160 basis points. It has fallen, since then, to 75 basis points, as the short end has priced in three to four Fed rate hikes in 2018, while the long end has remained anchored by the continuing expectations of low inflation in the United States.
The current shape of the yield curve is telling us what we already know: that we are not at the end of the cycle but are getting closer. As the renowned economist Rudi Dornbusch famously remarked, “No postwar recovery has died in bed of old age—the Federal Reserve has murdered every one of them.” This time will be no different.
How much time do we have left? Historically, it has taken an average of 202 trading days for the 10-year/1-year spread to tighten from 75 to 0 basis points. That would take us to New Year’s 2019. From there, it historically has taken an average of 303 trading days for a recession to begin. That would take us roughly to the end of the first quarter in 2020. Past performance is of course no guarantee of future results and averages can lie, but a simple, back of the envelope counting reveals that a recession is not in the offing for 2018 and is a fairly low probability event in 2019. When coupled with the still relatively benign U.S. inflation backdrop, which could conceivably draw out the Fed’s tightening cycle, we remain comfortable in asserting that the cycle has room to run.
Markets Still Offer Rewards
Is it worth it for investors to stick around for the last few years of market gains? Historically yes. The average return of the S&P 500 Index is 22.6% during the period when the 10-year/1-year spread tightens from 75 basis points, and then the yield curve inverts and a recession eventually begins. The median return on stocks over such periods is even higher.
Which asset classes have performed best as the yield curve flattens from 75 basis points to 0 basis points? Unfortunately, any analysis that could provide a definitive answer is limited by a dearth of data. What we can say is that investors, in this type of environment, tend to pay up for growth wherever they can find it. That growth was found with U.S. technology stocks in the late 1990s and with emerging market equities from 2004-2006. Currently, we favor U.S. growth and emerging market equities.
It is perhaps a sign of my age that I was tempted to write a Schoolhouse Rock song (The Yield Curve Is Flat, What’s Wrong With That?) to put the current state of affairs in perspective but I’ll resist the temptation. This cycle likely has room to run but it won’t go forever. The shape of the yield curve will be as good of an indicator as any other in projecting the cycle’s ultimate demise. For now, investors should expect more volatility but as the old saying goes, make hay while the sun is still shining.
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