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Stocktake: Don't fear the yield curve

Inversion may be economically significant but it doesn’t mean stocks are going south

Eugene Fama, the Nobel Prize-winning economist, found no evidence that inverted yield curves predict that stocks will underperform Treasury bills. Photograph: NYT

Proinsias O'Mahony's face
Proinsias O'Mahony
Tue Apr 12 2022 - 00:00

Talk of the recent US yield curve inversion, when two-year bond yields rose above their 10-year counterparts, continues to preoccupy investors.

Yield curve inversions are widely considered to be a valuable indicator of a future recession. However, as Stocktake has noted in recent columns, multiple strategists have stressed that any recession may be 18 months or so away.

Others add that this time really may be different or that the recent inversion was a brief affair. Furthermore, a recent Federal Reserve paper was titled Don't Fear the Yield Curve, stressing that the two- and 10-year yield curve was less predictive than other spreads.

Still, concerned observers counter that inversions cannot be dismissed. Yes, stocks can keep rising for some time, but that doesn’t mean this is a good time to buy, they say, pointing to various instances where medium-term returns were poor.

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Perhaps, but does that mean investors should be going to cash right now? One important 2019 paper co-authored by Nobel economist Eugene Fama suggests otherwise. Fama examined the performance of the US and 11 other major markets following 24 inversions across different yield spreads over a 43-year period.

“We find no evidence that inverted yield curves predict stocks will underperform Treasury bills” over the following one-, two-, three- and five-year periods, the paper concluded. Switching from stocks to cash underperformed a buy-and-hold strategy in all 24 instances.

In short, a yield curve inversion may well be economically significant, but it doesn’t mean stock markets are going south.

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