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David Blanchett and Michael Finke

Portfolio > Economy & Markets > Stocks

Is an Inverted Yield Curve Bad News for Stocks?

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What You Need to Know

  • Historical equity returns have been significantly lower in one-year periods when bill yields exceed bond yields.
  • Pivoting from bonds and equities into bills when the yield curve inverts has been a smart play historically, but investors need to be ready to move back when it normalizes.
  • This doesn’t necessarily mean that stocks shouldn’t be part of a portfolio when the yield curve is inverted.

In a recent article, we find evidence that bond investors should prefer Treasury bills in the short run — using historical global return data, longer-term bond returns are no more likely to be lower a year from today.

What about stocks? Inverted yield curves suggest that investors are pessimistic about future economic growth, but do stock prices accurately incorporate negative future sentiment?

There is some evidence from the academic literature that, at least in the U.S., future stock performance is lowest when yield curves invert early in a recession. Bond investors appear to do a much better job of predicting when a recession is likely to occur, but stock investors appear to be caught sitting on their hands (and on valuations that don’t reflect an increasingly pessimistic reality). 

This means that early in the recession when the yield curve inverts, stock valuations are higher than they should be and equity investors are subsequently punished with lower future returns. Once the recession is in full swing, valuations fall and equity investors are rewarded for accepting risk when investors require a high risk premium for buying stocks after they’ve fallen in value. 

The tendency to avoid risk when valuations are most attractive reflects our own findings from investor risk tolerance surveys. Investors are most risk tolerant when stock prices are high, even when the clouds of an impending recession appear on the bond investors’ horizon. They are also most risk averse when stock prices are low, which drives higher future performance for investors who can stomach investing after a loss.

Given the limited number of yield inversion periods in U.S. data, we look at historical global return on subsequent equity performance when yield curves invert. We focus on short-term (one-year) and intermediate-term (five-year) stock returns to see whether stock investors underestimate the impact of an inverted yield curve on short-term economic conditions.

When we sort by the yield spread between bonds and bills, we find evidence that historical equity returns have been significantly lower in one-year periods when bill yields exceed bond yields, although the effect clearly decreases over time.

Similar to our previous study, these results suggest pivoting away from bonds and equities into bills when the yield curve inverts has been a smart play historically, but investors need to be ready to move back into bonds or equities when the yield curve normalizes.

Analysis

Our analysis uses data from the Jordà-Schularick-Taylor (JST) Macrohistory Database, which includes 48 real and nominal returns for 18 countries from 1870 to 2020. Economic data for Ireland and Canada are not available, which is why only 16 countries are included in the analysis.

Bill yields exceed bond yields in only 24% of the historical periods, although the frequency varies by country.

We focus on one-year performance across countries for different yield environments, which is included in the following table. Note that we exclude periods were the returns on equities exceeds 200%.

Table: Average Future 1 Year Equity Returns by Country and Yield Environment

That historical data shows a clear monotonic relation between spreads on longer-term bonds and short-term bills. When spreads are lower, one-year stock returns are smaller.

The average 1-year stock return when yields are inverted is half (6.6%) the average return when the spread is 2% or more (13.2%). The lower performance in an inverted yield curve environment is consistent among all 16 countries in the study, and the spread is actually lower for the U.S. than in other countries.

Next, we look at the future five-year returns by country.

Table: Average Future 5 Year Equity Returns by Country and Yield Environment

Although less dramatic than one-year returns, there remains a 2.2% difference between five-year stock returns when the bond/bill spread is 2% or man compared to when the yield curve is inverted. This is consistent with the v-shaped opportunity set for investors in which subsequent stock performance just before an economy slows, rises when equity values fall, and eventually recovers at the tail end of a recession.

What Should Investors Do?

Although stock performance is lowest when yield curves invert, this doesn’t necessarily mean that stocks shouldn’t be part of a portfolio. On average, the performance is positive and there is still a risk premium. However, the reward for taking risk is smaller and this may suggest a lower optimal portfolio allocation for investors whose risk aversion is unchanged. Shifting portfolio allocations dramatically can also affect the tax efficiency of non-qualified portfolios and may not be worth the effort. 

It is important to take stock of where you are with respect to accomplishing a given financial goal (like retirement) and understand what a market correction would potentially mean for that goal. Clients who are basing their retirement age and lifestyle on today’s portfolio values are potentially at greater risk of having to make a significant readjustment when bond markets suggest trouble in the near future. It’s also important to temper expectations of future five-year stock returns when investing in an inverted yield curve environment.

Historically, the ability to earn 5% or more in cash-like instruments has been relatively rare. Not only do bills have higher yields than bonds, but the yield on cash/bills is quite attractive and represents an opportunity for advisors and clients to take a step back and ensure the portfolio is optimally positioned to help a client accomplish a goal.


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