One of the two US yield curves closely followed by investors – the differential between the 10-year and 3-month US Treasury bond – briefly inverted in March, although the 10-year/2-year differential did not. This means the yield on the benchmark 10-year bond was briefly lower than much shorter-dated 3-month security, when usually it is the other way around.
The phenomenon signals that the central bank is cooling down the economy by raising interest rates, which cause short-term rates to rise above long-term rates. However, research shows that it doesn’t follow that asset returns afterwards are negative, and the time lags between inversion and recession can be long, says Blokland, Senior Portfolio Manager with Robeco Investment Solutions.
“Our analysis shows that while asset class returns in general are somewhat subdued between the first date on which the yield curve inverts and the start of the recession, the inversion of the yield curve is not followed by extraordinary deviations in returns,” he says.
“In most empirical research, the yield curve is either defined by the 10-year/3-month US Treasury yield differential (10Y-3M), or by the 10-year/2-year (10Y-2Y) differential. The reasons for preferring one over the other depend on many things: in terms of data availability, the 3-month US Treasury yield has a much longer history. However, the degree to which you want to capture short-term versus long-term views on GDP growth and inflation is likely to be better reflected in the 2-year yield.”
“The yield curve qualifies as one of the best, if not the best, recession forecasters. For the 10Y-2Y yield curve, we have reliable data covering the last five US recessions, all of which were accurately forecasted well in advance. The lag between the first ‘inversion date’ and the start of the recession, as determined by the National Bureau of Economic Research, averages 21 months, ranging from 11 months until the 1981 recession to 34 months until the 2001 recession.” This is shown in the table above.
“The results for the 10Y-3M yield curve are highly comparable, with an average lead time of 19 months until the next recession. The data further reveals that prior to the last five recessions, the 10Y-2Y yield curve inverted before the 10M-3M yield curve on each occasion. From this angle, the 10Y-2Y yield curve should be the preferred recession indicator, as it ‘detects’ the next recession first.”
“The available data history for the 10Y-3M yield curve is longer, covering the last seven recessions. We find that the 10Y-3M yield curve correctly predicts these two additional recessions (1970, 1973) as well.”
So, what does this mean for future asset class returns? The table above shows the average and median annual returns on most major asset classes, covering US stocks, global stocks, commodities, gold, US Treasuries and US corporates, as well as US real GDP growth for both yield curves, between 1978 and 2008, when the last US recession occurred.
The returns are calculated as the index change between the first negative reading of the yield curve leading up to a recession, and the first day of that same recession. It therefore illustrates performance between the inversion date and the start of the recession.
“As can be derived from the table, this was an exceptionally strong period for both stocks and bonds, with average annual returns above their longer-term history,” says Blokland. “While there are differences between the returns calculated using the 10Y-3M and 10Y-2Y yield curves, the results are highly comparable.”
“Second, while the variation in returns is substantial, they are far from extreme. For example, the average and median annual return on all asset classes is positive. No asset class shows severe and structural weakness after inversion, with only gold realizing a negative return in three out of the five inversion periods, and gold returns are pretty erratic in any case.”
However, the research confirms that investors should be cautious about credits and global equities, and more optimistic about commodities, if we are indeed late in the economy cycle, Blokland warns.
“The deviation from the full sample average return is relatively large for US corporate bonds,” he says. “This fits the perception that credits tend to struggle late cycle, as short-term interest rates are lifted by the Federal Reserve and leverage tends to be high.”
“Lastly, with a 7% return, commodities are the only asset class which realized a much better return than the full sample average (2.8%) after yield curve inversion. This fits the characterization of commodities as ‘being late cycle’.”
“Still, as we believe it is possible to establish that we are in the later stages of the economic cycle, it could prove prudent to become somewhat less enthusiastic about the return prospects of corporate bonds (as reflected in our multi-asset portfolios) and be a bit more optimistic about those of commodities.”
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