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Yield Curve Inversions Are Rare: A Historical Review Across Dissimilar Asset Classes (Part 1)

2018 MarketSelloff
  • 30 Year U.S. Treasury Bonds should provide the clearest picture in terms of forecasting
  • Absolute low interest rate environments can skew typical market signals
  • Inversions tend to arrive years in advance of actual recessions

Authored By: Mason Stark, Head of Wilshire Phoenix Asset Management

The interest rate yield curve inverted last August, and most in the financial community concluded that a recession was imminent.

As you can see in the chart below, the grey areas denote recessionary periods, when Gross Domestic Product (GDP) shows negative rates of growth for two periods consecutively. Also, the yield curve inversions clearly arrive before actual recessions, suggesting this is a very useful forecasting tool. However, one should also note that inversions tend to arrive years in advance of the actual recessions.

post-Yield Curve Inversions Are Rare-1

Source : https://fred.stlouisfed.org/series/T10Y3M

Therefore, using this tool as stand-alone is probably not the best idea, but ignoring it completely is likely a mistake, by using history as a guide.

While much has been discussed concerning an inversion’s track record for economic activity, little has been addressed regarding the historical track record of financial assets after an inversion.

Recent inversions and their influence on United States Equities and Treasuries

Most of the concerns around yield curve inversions seem to center around equities. We shared the below chart on Twitter recently, and of note, the most recent curve inversions were before the major declines in 2000 and 2008. Interestingly, each inversion occurred about 21 months prior to each respective peak in the S&P 500 Index (SPX).

Then in 1988, a curve inversion ensued after the crash of 1987. In this instance, the SPX climbed steadily thereafter, however, the ascent eventually stalled leading up to a recession in the early 90’s.

post-Yield Curve Inversions Are Rare-2

Source: Bloomberg. (Green Line denotes 30 Year – 3 Month Libor Spread, White Line denotes S&P 500 Index Price, Red Lines denote the start of Yield Curve Inversions)

In the above, we show 3-Month Libor versus the 30 Year U.S. Treasury Bond. The reason for using the 30 Year versus the 10 Year (that most employ), is due to the inherent pull of the Fed Funds Rate the closer in time the security is on the curve.

To put this another way, the 30 Year is the furthest away from the Fed Funds Rate so that should provide the clearest picture of what the U.S Bond market is forecasting for the economy in the longer-term.

Provided however, in such an absolute low interest rate environment, interest rates can skew typical market signals. For example, the rally throughout the last several months in fixed income plunged the 30 Year Rate to a new all-time low, while the 10 Year Rate has not surpassed its low from 2016. This is likely due to the Fed Funds Rate essentially at zero back in 2016, versus the 2.00%-2.25% currently.

In this Part I, we intended to provide a general foundation of yield curve inversions. In Part II, that foundation will be applied in a deep-dive across numerous asset-classes.

Mason Stark is a Partner of Wilshire Phoenix and is the Head of its Asset Management Group. He has over 25 years of experience in the hedge fund industry and capital management. Mason began his career at Granite Capital as an Equities Analyst and Trader, before leaving as the Head of Granite’s Trading in 2000 to join Ramius Capital Group (RCG). As Managing Director at RCG, Mason built the Hedged Equity Group, managing more than a billion of gross invested capital. In 2010, Mason, and two other original RCG members, founded Ballast Capital, LP, and guided it through a successful seed round led by Investcorp. From Ballast, Mason went on to numerous appointments, including Ambi Advisors and wealth management with The Healy Group. Mason is a graduate of Sarah Lawrence College with a B.A in Economics and International Relations. Mason has also obtained the Series 7, 56, 63 and 65 Licenses.

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