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Recessions, The Stock Market & Inverted Yield Curve, Oh My!

BLOG, MARKETS & ECONOMICS  |  20 Jan 2016

By Jon Aldrich

Inverted Curve

Stock markets around the world continue to struggle and many are in panic mode right now. The chart of the stock markets looks eerily similar to the image above. The S & P 500 index is down almost 10% since the start of the year which signals a “correction”. Remember, 10% is a correction and 20% is a “Bear Market”. However, I chuckle a bit, because if we only drop 19.9% it is truly not a bear market. Realistically, anytime stocks drop it feels like a Bear Market to many of us. However, the economy appears to be doing modestly well and continues to grow, although not as brisk as many would like, I will admit. That leads me to discussing stock market sell-offs and economic recessions.

Ben Carson, who writes the excellent A Wealth of Common Sense blog recently wrote an article discussing stock market returns after sell-offs (like we are having now) that occurred without a recession. Often times when large market corrections occur, they happen around the same time or just before the U.S. economy plows into a recession. 2007-2008 and 1973-1974 are a couple of examples that come to mind. However, plenty of market corrections take place when there is not a recession, 1998, 2010, 2011 are some of the most recent occurrences.

By all indications, we are not currently headed into a recession, of course it is always possible that could change a few months from now, but as of now, we are not in a recession. Consumer sentiment remains high, employment continues to improve as the unemployment rate continues to drop, Gross Domestic Product (GDP) is not blowing anyone’s doors off, but continues to be positive, and several other indicators such as wage growth, home prices and auto sales continue to improve.

U.S. Consumer Sentiment

U.S. Unemployment Rate

Ben provided this chart below in his article which listed instances going back to the late 1930’s when the S & P 500 had at least double digit losses without a recession.

S&P 500 Double Digit Losses

Source: A Wealth of Common Sense.com  1/17/2016

As you can see in the chart above, there have been many double digit losses over the years that occurred without a recession. All of the above losses are currently greater than what we have observed so far. The key is to look at the subsequent returns of the S & P 500, five & ten years after the bottom of the sell-off. In almost every instance markets were considerably higher. Those that panicked and sold out of everything when they thought the sky was falling likely missed the strong rebounds.

The Stock and Bond Markets- Predicting Recessions

The stock market is known as a forward looking indicator, and market participants are looking to discount future economic events. However, the stock market often misses the mark. There is an old saying that goes, “The stock market has predicted 9 of the last 5 recessions.” This is in reference to the fact that the stock market often gets the future wrong, and cries wolf a lot of times in regards to a recession, even though one never occurs.

The bond market seems to provide a more reliable indicator for calling an upcoming recession known as an “inverted yield curve”. What the heck is this, you may ask? An inverted yield curve occurs when short term interest rates (e.g. the 3 month Treasury bill) yields more than longer term interest rates (e.g. the 10 year Treasury note). In most occasions, interest rates on longer term bonds yield more than shorter term bonds as an investor would seek to earn a higher return when they are tying up their cash for a longer period of time. Short term interest rates are more influenced by the Federal Reserve, while longer term interest rates are dictated more by economic expectations of the bond market.

Often times before recessions as the Federal Reserve raises short term rates to stem inflation, the short term rate can temporarily become higher than the longer term rate. In the chart below (which shows current interest rates), the short term rate is denoted in red and the longer term rate in blue. When the red line gets above the blue line, the yield curve is labeled as inverted. The last time this occurred was in 2007 and the inverted yield curve has correctly predicted the last 7 recessions going back to the late 1960’s. Only the last 3 recessions (shown in grey) are shown. Currently (as of Jan 19th) the 3 month Treasury bill yields 0.237% and the 10 year Treasury note yields 2.039%, so the longer term rate is still quite a bit higher than the short term rate, which would tend to indicate that the odds of a recession in the near future may not be all that great.

10 Year Treasury Constant Maturity Rate

Source: Federal Reserve Bank of St. Louis (when the red line moves above the blue line, it is said to be an “Inverted Yield Curve” and often a sign of an impending recession.

So, even though the bond market is not calling for a recession, it is also not calling for robust growth either, or the 10 year Treasury would likely be yielding much more than the 2% it is currently yielding. It likely suggests we are in for more of the same lukewarm economy for the near future. The economy has been this way the last several years and it has been a good environment for stocks. Maybe a lukewarm economy is not all that bad after all.