Sept. 2019 Rate Inversion, the Economy, and the Stock Market

A great deal of attention is being paid to yield curve, which is currently “inverted”, and what that might portend for the economy as well as the stock market. Investors should be circumspect with regard to the headlines. Recent research provides more useful insights.

The U.S. yield curve plots current interest rates for fixed income securities ranging from one month to thirty years. Normally this curve is upward sloping, indicating a positive relationship between rates and bond maturity; that is, long term bonds provide higher yields than short term bonds. This is because long term bonds lock up an investor’s capital for a longer period of time, so they bear greater term risk. All else equal, a long-term bond investor is rewarded for assuming this risk.

Occasionally, however, yield curves invert, so that short term rates rise above long term rates. Inverted curves have preceded the last seven recessions, and several empirical studies show that the slope of the curve is a reliable predictor of economic activity. In fact our parent, AIER, includes the steepness of the yield curve among its leading indicators of expansion or contraction.

This outcome often leads investors to ask whether the inverted curve also predicts low stock market returns, and whether negative returns could be avoided by reducing equity exposure after the yield curve has inverted. Recent research (Fama French, July 20191) evaluated this question by studying yield curves in the U.S. and in developing countries spanning capital market data between 1975 and 2018. They found no evidence that yield curve inversions can help investors to avoid poor stock returns.

We are not surprised by this finding. The stock market after all, like the yield curve, is itself a leading indicator of economic activity. The stock market is a forward-looking mechanism that constantly discounts information as soon as it becomes available. Yield curve data is readily available to the investing public, so there is no reason to believe that any predictive information it might reveal would not be reflected in current equity prices.

Also In This Issue

The Return Of The Century Bond
A Tale Of Two Decades: Lessons For Long-Term Investors
Risk: More To The Story
A Reader Inquires
Negative Interest Rates And Your Bond Portfolio
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow Jones Industrials Ranked By Yield
Asset Class Investment Vehicles