What are interest rates telling us about the current state of the economy? And, more importantly for investors, what are they telling us about the markets?

A few weeks back Ben Carlson had a good post addressing the first question. He asks what interest rates (specifically the spread between 2-year Treasury yields and 10-year Treasury yields) are telling us about the likelihood for a recession. Here’s Ben:

The indicator most industry observers pay close attention to in terms of bonds and recessions is the spread between 2 year treasury yields and 10 year treasury yields, which you can see here:

When the 10-year yield falls below that on 2-year treasuries it’s called an inverted yield curve, and Ben writes:

You can see that every single time that 10 year yields have fallen below 2 year yields it has preceded a recession (the shaded regions). This data only goes back to the late-1970s but is impressive nonetheless.

Next, he correctly points out that just because something is a reliable historical indicator, to expect it to work in the future, there must be a sound, fundamental explanation of why. Again from Ben:

In this case there is a logical reason for using the yield curve as an economic signal. Bond yield spreads are typically used to gauge the health of the economy. Wider spreads between long-term and short-term bonds lead to an upward sloping yield curve, which can indicate healthy economic prospects — most likely higher growth and inflation in the future. Narrower spreads lead to a flatter or even negatively sloped yield curve, which can indicate poor economic prospects — most likely lower growth and inflation.

His accurate conclusion is that we should pay attention to this indicator. We aren’t yet at an inverted yield curve with the current spread around .80%, but, with the spread falling, it is worth watching.

However, I was left wondering about the second question. What do interest rates and the yield curve mean for the markets (as opposed to the economy) going forward? If an inverted yield curve means a recession, that’s probably pretty bad for stocks, right? Well, not quite. Let’s take a look.

What does the yield curve tell us about stock returns going forward?

Data on the 2-10 spread goes back to the late 1970’s and since that period the average spread is right about 1%—Meaning, on average, a 10-year Treasury bond has a 1% higher yield that a 2-year Treasury. Again, the current spread is right about .80% but declining.

What happens to forward returns on stocks when this spread is steep (which I’ve defined as greater than 1%), flat (0-1%), or inverted (less than 0%)?

As you can see, the best periods for stocks have followed a starting 2-10 spread of between 0-1%—as it is currently. The worst periods, as we would expect given its ability to forecast recessions, follows an inverted yield curve.

But, an inverted curve doesn’t inevitably spell disaster for stocks. The average return, both 12 months and 24 months later, is only a bit less than the overall average and still strongly positive. What’s more, there is a wide range of outcomes following periods where the curve is inverted. The worst 12-month return was -26.6% (the period ending October of ‘00) but the best period was a staggering 52.4% from July of ’81 to June of ’82.

Once the yield curve does go negative (if it does), it doesn’t automatically spell trouble for stocks. Sometimes stocks rise from there, or sometimes the damage is already done. It isn’t a reliable timing indicator to move out of stocks.

But what about the bond market?

The Yield Curve and Bond Returns

An inverted yield curve does reveal a bit more about forward returns for bonds than stocks. This makes sense as a bond ultimately derives it’s return from the starting yield plus any change in price (and bond prices move inverse to interest rates). The wider the yield spread between long-term and short-term rates, the larger the starting income differential and the more room the yield curve has to flatten driving up long-term bonds returns.

In the chart below we see, as we would expect, that the most favorable time to be in long-term bonds compared to short-term bonds is when the yield curve is steep (a higher yield spread and more room for rates to come down). Long-term bonds returned 2.3% and 1.8% more than short-term bonds over the next 12 and 24 months respectively when the yield curve was steep—this compares to 1.4% on average over all periods. The least favorable period is when the yield curve is inverted, with a slightly negative premium to long-term bonds over 12 months and just a .5% premium over the next two years.

Despite its prior success as a harbinger of recessions, when it comes to making an investment decision based on the yield curve, be careful. With stocks, it doesn’t appear to be a useful timing indicator. With bonds, however, it does tell you a bit more—if you are not getting compensated to take the interest rate risk associated with long-term bonds, it’s been historically beneficial to minimize this exposure, at least over the next twelve months.

It’s fine to keep an eye on the yield curve, but don’t use it to time your equity allocations.

Bonds prices and interest rates are like different ends of a teeter-totter. When interest rates go down, for example, prices rise. And the magnitude of this change (the increase or decrease in price) is measured by the duration of the bond. So in other words, the duration of a bond is like your position on that teeter-totter. The longer the duration, the further up (or down) bond prices move. So with bonds, the longer the duration, the more impact a change in interest rates will have on the current value of the bond.

 

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