The Best Investments in Case of an Inverted Yield Curve

The yield curve has fallen to its flattest level since the 2007-09 recession which can cause bond-market investors to take notice and start bracing for a possible inversion. Traditionally safe assets like long- and short-term bonds have fared a bit better following yield-curve inversions.

Source: Wall Street Journal

The yield curve—the difference between the interest rates available on shorter-term and longer-term Treasury bonds, shown as one curved line—generally slopes gently upward in normal times, as investors demand more return on investments that tie up their money for a longer period.

Recently, however, the yield curve has fallen to its flattest level since the onset of the 2007-09 recession. When rates of different maturity Treasurys get so similar, bond-market investors take notice and start bracing for a possible inversion of the curve, which is when short-term yields surpass long-term ones. A flattening of the yield curve suggests that investors are getting worried about near-term growth and leaves some pundits eager to predict the economy is headed for a downturn.

This past week, the spread between the 10-year and two-year Treasury fell to just 0.24 percentage point. Should it continue on this trajectory and actually invert, history shows that investors shouldn’t hold out much hope for monumental returns across any asset class in the years that follow.

An investigation of the 10 yield-curve inversions (when the rate on the two-year Treasury exceeded that of the 10-year Treasury) that have occurred since the buildup in the 1920s to the Great Depression found that large-cap stocks delivered an average annual rate of return of just 1.5% in the two years following the inversion. Worse, small-capitalization stocks averaged minus 3.1% over the same time frame.

Counter to this, traditionally safe assets like long- and short-term bonds have fared a bit better following yield-curve inversions. Following the 10 inversions, long-term bond portfolios averaged an annual rate of return of 6.2% and short-term bond portfolios averaged 5.5% in the two years following an inversion.

Not only do stocks appear to deliver the lowest returns following yield-curve inversions, they deliver the greatest volatility in these time periods, as well. For instance, large-cap stocks lost more than 50% of their value in a two-year period following the 1929 yield-curve inversion (leading into the Great Depression). On the positive side, large-caps delivered gains of more than 20% in the two years after the 1981 inversion.

While the historical evidence seems to suggest that safer assets perform better on average following an inversion, it is important to note that inflation has averaged 4.5% following these events. That further reduces the attractiveness of all of these investments. In fact, once the inflation rate is factored in, the only asset class that historically has even a positive real rate of return following an inverted curve are bonds, with an average portfolio of short- and long-term issues registering a paltry 1.3% annual real rate of return.

Interestingly, the yield curve has become a much better predictor of recessions in recent decades. An inverted yield curve has accurately predicted every recession going back to the mid-1960s, with only one false positive, in 1966. Yet, from 1926 to 1966, eight recessions occurred and only twice did an inverted yield curve manifest within a year before a given recession.

All told, the data suggest that prices (especially equities) respond much more to an inversion than to the actual recession, which comes on average 12 months later. In 75% of cases over the past 90 years, the two-year returns to large-cap stocks are significantly worse following an inversion than they are following an official recession.