The ‘yield curve’ inversion is spooking the markets. Although it’s a recession predictor, history shows it may not be time to sell

The inversion is warning signal that the markets are expecting the economy to worsen, and served as a fitting end to the worst quarter for the S&P 500 in two years. The Dow ended the day down 1.56% at 34,678, the S&P 500 lost 1.57% to close at 4,530 and the Nasdaq Composite fell 1.54% to end the day at 14,220.52. Here’s what investors need to know about the yield curve inversion, how often it has accurately predicted a recession, and what it means for stocks going forward.

What is a yield curve inversion?

In a “normal” market environment, yields for shorter term bonds are lower than those with longer maturities. Makes sense, right? As Fortune explained in 2019 the last time we saw the yield curve invert: “Yield curves are a way of comparing the interest rates of the different maturity-date bonds a country issues—like U.S. Treasurys. In a normal market, interest rates (called yields) for longer-term bonds should be higher than those for shorter-term ones, because investors tie their money up for a longer time and want a greater reward for doing so.”

A steep yield curve is a sign that investors are expecting brisk economic activity going forward. But a yield curve inversion is when that equation flips. Suddenly two-year are higher than 10-year rates. That’s a sign that investors are expecting a slowing economy—they think short term conditions are better than those further out.

Why is the yield curve inverting now?

There’s a combination of factors at work here. Bond prices move in the opposite direction of yields—so when demand for bonds fall, their yields rise (and vice versa, when prices rise, yields fall). Anu Gaggar, Global Investment Strategist for Commonwealth Financial Network wrote in a recent note that shorter term yields have risen as the market prices in a string of rates hikes this year as part of the Fed’s campaign to stem inflation, and that longer-term rates have risen as well, but not by as much. He pinpoints four reasons why:

1. There is demand for long-term Treasury paper from pension funds that need to match the duration of their liabilities with their assets. They are also looking to de-risk after a few strong years of returns from their equity holdings.
2. U.S. Treasuries are a popular holding for global central banks, both because of the reserve status of the U.S. dollar and because U.S. Treasuries are trading at higher interest rates than government paper in most developed countries.
3. The Fed was purchasing Treasuries up until the last Fed meeting in March, in order to pump liquidity into an economy recovering from the pandemic.
4. With heightened geopolitical risks, U.S. Treasuries act as a safe haven for investors.

Does a yield curve inversion always mean a recession is coming?

Not always.

“Yield curve flattening and, ultimately, inversion are features of an economy that is shifting gears from midcycle to late cycle,” writes Gaggar. The market starts to price in rate hikes by the Fed as the recovery gathers steam during midcycle. In the late cycle, markets begin to fret that tighter monetary policy could take the wind out of the economy and a downturn might be approaching. It is widely believed that an inverted yield curve is a harbinger of recession.”

Gaggar reports that there have been “28 instances since 1900 where the yield curve has inverted; in 22 of these episodes, a recession has followed.”

How have the Fed’s recent actions impacted the yield curve?

One interesting theory is that the Fed’s massive bond-buying program has had an outsized effect on yields. Richard Bernstein Associates, an investment manager, calculated that “if the Fed had never engaged in quantitative easing, the 10-year yield could be closer to 3.7%. Were it not for the central bank’s bond-buying program, the yield curve for the 2-year and the 10-year would then be more like 100 basis points apart, instead of inverted. (1 basis point equals 0.01%.),” according to CNBC.

Does a yield curve inversion mean the stock market is going to crash?

If you’ve ever heard the saying “don’t try to time the markets,” the lag between an inversion and any resulting selloff is certainly proof of how hard it is to judge when a stock market crash may come. According to Gaggar’s research, “even when the yield curve inverts, it’s a poor signal for getting out of risk assets such as equities. Late cycle is not the same as end of cycle, and equities may continue to offer positive returns. In the six episodes of yield curve inversion since 1975, global equities have, in aggregate, risen in the 12-month period after the inversion.”

However, “While equities have risen after the yield curve inversion, returns have generally been weaker than the pre-inversion period. Defensive sectors have typically outperformed cyclical sectors in the 12-month succeeding the 2s10s inversion,” writes Gaggar.

So yes, an inversion is a red flag. And possibly a signal that it’s a good time to rotate into value stocks or position your portfolio defensively. But not a sign to panic.