Steepest yield curve inversion ever?

What happens to stocks and bonds now?

“Normal” is a term we see appear in the English language in the 17^th century as a form to standardize measurement. The Latin word normalis is directly referencing something made with a carpenter’s square, forming a right angle.

In the bond market, we also have a tool that defines normal: an upward-sloping yield curve. That means that yields on longer-term bonds are higher than those on shorter-dated bank deposits or Treasury bills and notes. Yield curves are upward sloping to compensate investors for the added risk of tying up their money for longer periods. Longer-term bonds carry greater risk of various potential losses, ranging from inflation to default. Investors therefore normally require an additional return, in the form of higher yields, to offset the risks of venturing out along the yield curve.

Today, however, most parts of the U.S. Treasury yield curve (and many foreign government-bond market curves) are inverted, meaning that short-dated deposits, bills, and notes offer higher yields than those on longer-dated bonds.

While a recession has not followed every instance of an inverted curve, the Federal Reserve (Fed) Bank of Chicago has shown that each time the yield spread between 10-year and 2-year Treasuries has inverted since 1969, a recession has followed.¹

So with today’s deeply inverted yield curve, I thought it was worth exploring three topics at the Franklin Templeton Institute: 1) How does this inversion compare to previous episodes; 2) What is the historical impact on equities?; 3) What is the historical impact on bonds? Based on these observations from the past, we can better evaluate if there was a pattern and whether we can discern any reasons and or lessons for the future.

Cause or effect?

Inverted yield curves are often the byproduct of tighter monetary policies. When central banks, such as the U.S. Fed, deem it necessary to hike interest rates to cool overheated economies, their actions cause short-dated interest rates to rise faster than yields on longer maturities.

One might ask why long-term interest rates don’t rise as much (or even more) than short rates when central banks are tightening. A key reason is that modern central banks have garnered considerable credibility in keeping inflation low. When they tighten to fight inflation, investors are quick to conclude that they will triumph, even if the cost of slaying inflation is weaker economic growth, perhaps even recession. Further along the yield curve, therefore, investors must not only discount higher short-term rates due to tighter monetary policy, but also its probable outcomes, above all lower inflation and economic weakness. As a result, when central banks tighten policies, yield curves initially flatten and then often invert, as is the case today.

Presently, the U.S. yield curve is inverted – as measured by the gap between the 10-year Treasury note yield and the 2-year Treasury note yield – by nearly three quarters of a percentage point. Relative to history, that is a big negative spread (Exhibit 1). In all previous Fed tightening episodes since 1989, the yield curve has never been as inverted as it is today. The only time in the postwar period when the gap between long and short rates was even more negative was during the early 1980s, when the Fed under its super-hawkish chairman Paul Volcker hiked short-term interest rates to 20%!

As Exhibit 1 also demonstrates, inverted yield curves are aberrations, neither frequent nor long-lasting. The average length of U.S. Treasury yield curve inversion in the postwar era, for example, is eight months.

Stocks and bonds react differently

Accordingly, whenever the yield curve is inverted, investors ought to anticipate its normalization. Moreover, as our research shows, U.S. Treasury yield curve normalization typically takes place in the context of falling interest rates, what Wall Street terms a “bull steepening.” In those instances, both short- and long-term interest rates fall, with the front end (shorter-dated maturities) rallying more than the long end.

Unsurprisingly, therefore, a bull steepening is bullish for fixed-income markets. Prices rise along the yield curve (and across many credit markets), boosting fixed-income total returns in excess of coupon rates.

One might conclude that equity investors would also be pleased with falling interest rates. All else equal, after all, lower interest rates should boost equity valuations. And U.S. bond yields have fallen in recent months, giving stocks a lift despite slowing profits growth.

However, history gives us a more nuanced picture. During periods when the yield curve shifts from inverted back to upward sloping, stock markets typically sag. In those same episodes, total returns on bonds top those on equities in absolute and risk-adjusted terms (Exhibit 2).

Next time: The outlook for stocks and bonds, and implications for investors.

Stephen Dover, CFA, is Franklin Templeton’s Chief Market Strategist and Head of the Franklin Templeton Investment Institute. Originally published in Stephen Dover’s LinkedIn Newsletter Global Market Perspectives. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.

Disclaimer

What are the risks? All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.

Important legal information. This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.

Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FTI affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com - Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton Investments’ U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.