What does the yield curve inversion mean?

Ed Mertiri |

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US equity markets break through first levels of resistance despite yield curve inversion

 

Last week produced a yield curve inversion across 2- to-10 year notes. The past week also had a small inversion between the 20 year and 30-year yield but both still trading higher than the 10-year. (see chart)

The inversion was relatively small and concentrated around the shorter-term treasuries and the 10-year yield. This implies investors expect higher interest rates in the short term (most related to inflation and rate hikes) but slowing growth farther ahead. The inversion does not guarantee a recession. The US could likely face stagflation or a brief recession, meaning 2 consecutive quarters of contracting GDP growth. Historically if a recession occurs, the slowing growth typically happens 12 to 18 months after the yield curve inversion. The current inversion could also cause by investors reacting to hawkish comments from Federal reserve and trying to buy ahead of rate hikes.

Since we are investing for today and looking at more of 3-to-6-month horizon, a possible recession in 12 to 18 months isn’t a key data point to use for today’s investing. Even if a recession happens it is unclear how long or deep it would be and how markets will react. Most importantly a recession doesn’t always coincide with a bear market. A recession is based on quarterly US GDP growth, it is not perfectly coordinated with US equities.

Investable markets are forward looking and are driven by investor sentiment, not just purely based on what companies achieve. During the 2008 financial crisis the US equity market very closely followed the US economy, dipping into a bear market for most of the months of the recession. But that was not the case in the recession of the mid 70’s. Equity markets climbed higher in 1974 and 1975 despite 3 quarters of contracting GDP growth. If investors believe the contraction is to be short lived, they will continue to invest in the future of company potential. While we watch for all indicators continuously, including the robust jobs report last indicating unemployment has reached pre pandemic levels. We keep a sharp focus on company fundamentals when it comes to equity investing.

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