The Truth About the Yield Curve, The Economy and The Stock Market

• Yield Curve Inversion and Recessions
• Using the Economy to Forecast the Economy
• What Happens to the Stock Market after an Initial Inversion?
• Yield Curve Conclusion
• Catch a Falling Knife, Anyone?

By now, everyone and his dog is aware that the yield curve has inverted. An event such as this is usually confined to professional money managers and analysts, but the 2019 inversion has appeared in virtually every newscast in the country. For instance, the yield curve was mentioned in four of the six network Sunday shows. It's what I call a thin reed indicator; I've described it before in my book Investment Psychology Explained. To quote the book, "A form of thin reed indicator occurs when you read a story in a general purpose magazine that is highly technical or specialized in nature."

An article on the yield curve would not be out of place in The Wall Street Journal or a financial web site, where this kind of thing is mentioned all the time. However, it is out of the ordinary to see such a comment in the general purpose news media. To quote the book again – "Such an item generally indicates that an investment idea that is normally confined to a select number of speculators and professionals now has a more widespread acceptance. For 'widespread' the contrarian should read 'potential reversal'."

The current inversion hysteria is being used both as a forecaster of a recession, which we will get to later, and a dog whistle for a bear market in stocks. On contrarian grounds, it seems likely that neither will take place, but what do the facts say?

Yield Curve Inversion and Recessions

There are many ways of measuring the curve, which compares a short-term with a longer-term interest rate, but I will be using the 10-year/2-year spread as that is the relationship most commonly followed and currently attracting widespread attention. For the vast majority of time, the 2-year maturity trades below its 10-year counterpart due to the higher risk associated with the longer-term maturity. When the 2-year trades above the 10-year, that usually reflects a monetary policy that is growing tighter and likely to result in a recession. In fact, every recession in the last 50 years has been preceded by an inversion. The problem is that a recession can occur without a yield curve inversion. The history of the 10/2 curve only goes back to the 1970s. However, substituting the corporate yield curve, which has a longer history, indicates that the recessions in 1926 and 1937 were not associated with an inversion in which the yield on 3-month commercial paper moved above that for Moodys corporate AAA yield.

The pink-shaded areas in Chart 1 flag recessions. We can see that each recession in the last 30 years was preceded by an inversion. The problem lies in the fact that the lead times have varied from being almost non-existent in 1990 to over two years for the 2001 and 2007 contractions. A couple of those leads have been flagged with red arrows. Knowing that the yield curve has inverted is obviously an advantage in forecasting a recession, but it lacks a lot in the timing department. For instance, the last two recessions were not only preceded by a long lead, but that process involved several inversions, as flagged by the blue arrows. Consequently, I am not that sure that it would've been very helpful in knowing in May 1998 that a recession was on the way if you didn't also have the knowledge that that it would fail to materialize until 2001. A better approach, in my view, is to combine the yield curve analysis with a leading economic indicator. In that way, the yield curve inversion warns you a recession is likely, but the economic indicator gives you a better indication of when it will likely happen.

Chart 1

Using the Economy to Forecast the Economy

No economic indicator is perfect, but the Chemical Activity Barometer, published by the American Chemistry Council, has called every recession since 1919. The lead has ranged from 2-14 months, with an average of 8 months. I have plotted it in Chart 2. (You can follow the latest data here.) It seems particularly good at identifying recessions when its PPO, using the 3- and 18-month parameters, crosses decisively below zero. The latest July reading shows the indicator to be a tad above the equilibrium line, so a recession can by no means be ruled out. The numbered blue arrows flag the three slowdowns that have characterized the current (post-2009) recovery. The big question obviously relates as to whether the third slowdown will experience a soft landing by bouncing from the equilibrium level once again. Alternatively,we might ask if it will drop below zero, a condition that has, without exception, signaled every recession since the 1960s.Sometimes a move below zero has confirmed that a recession is underway and sometimes it has led the contraction in business activity.

Chart 2

What Happens to the Stock Market after an Initial Inversion?

Naturally, if a recession has followed an inversion in every case since the 1960s, we should expect the stock market to suffer some pain, shouldn't we? Chart 3 gives us the answer. The vertical lines indicate the initial inversion following the previous recession. Red flags a bearish scenario, blue a challenging one and green a positive outcome. It is fairly evident that we have a mixed bag, which leads to the conclusion that, whilst an inversion may be followed by an initial sell-off, such as 1998, it cannot generally be used to forecast a bear market. Two things I'll be looking out for will be a negative 12-month crossover by of the S&P's 12-month MA and a decisive drop below zero by the 18-month ROC. You can appreciate the significance of a negative ROC crossover from the pink-shaded areas, which flag previous extended negative ROC. Only the 1988/9 situation turned out to be profitable, but this was due to the statistical quirk of the 1987 crash.

Chart 3

Yield Curve Conclusion

The recent yield curve inversion gained unprecedented publicity last week. From a contrarian aspect, that suggests that conventional wisdom concerning a near-term recession and an adverse stock market performance is unlikely to pan out. A recession will certainly take place at some point, but, as long as the S&P remains above its 12-month MA and is supported by other long-term indicators including the Chemical Activity Barometer, the recent dip may prove to be more of a buying opportunity.

Catch a Falling Knife, Anyone?

Last weeks election favoring a return to Peronist governance triggered a close-to-30% decline in the Global X MSCI Argentina Fund (ARGT). Some of the loss was recouped by the end of the week.

Chart 4

Good luck and good charting,

Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Groupof Walnut Creek or its affiliates.