A Changing Yield Curve Signal
Changes in the yield curve tell a story even if the current inversion has not
In 2021 and 2022, there was a surge in news articles and pundits talking about the inverted yield curve and the impending recession it was foretelling. For decades, the yield curve has served as one of the more stalwart recessionary indicators, inverting before each of the eight previous US recessions.
As a refresher, the yield curve (composed of US Treasurys) is generally upward-sloping, to account for the fact that lenders demand extra compensation for making longer-term loans due to increased uncertainty about the future. An inverted yield curve—where short-term rates are higher than long-term rates—is uncommon, occurring only 10-15% of the time, depending on the definition, since 1976. Mechanically, the argument goes that when the yield curve is inverted, it reflects investor expectations that the Fed will cut interest rates, generally done to stimulate a sputtering economy, implying that future rates will be lower than current rates.
Despite all the noise in 2021 and 2022 about the yield curve, the US economy appears to be humming along just fine, with the yield curve remaining stubbornly inverted. This has perplexed investors, as highlighted in a recent Wall Street Journal article: “The yield curve has been inverted for a record stretch—around 400 trading sessions or more by some measures—with no signs of a major slowdown.”
The recessionary implications of the most recent yield curve inversion remain an open question. However, we think a more interesting question is what an inverted yield curve means for asset class and factor returns. In that context, changes in the yield curve (i.e., one month change in the 10-year minus three-month yields) tell a much more interesting story.
Below we show average forward one-month excess returns versus yield-curve trend deciles since 1996 for a selection of factor returns.
Figure 1: Forward 1M Pure Factor Returns vs. Yield Curve (Trend)
Note: Factor returns from Verdad’s factor model, constructed via Fama–MacBeth regressions
Source: Capital IQ, Bloomberg, Verdad analysis
As shown above, safe-haven assets like US equities, utilities, real estate, and US Treasurys tend to do better when the yield curve is inverting (investors are more pessimistic about the future). These same asset classes and factors tend to do worse when the US yield curve is steepening (investors are more optimistic about the future).
We can see this same pattern in reverse reflected in the following asset classes.
Figure 2: Forward 1M Pure Factor Returns vs. Yield Curve (Trend)
Note: Factor returns from Verdad’s factor model, constructed via Fama–MacBeth regressions
Source: Capital IQ, Bloomberg, Verdad analysis
In Figure 2, we can see that risk-on assets like small-cap equities and emerging market equities tend to do better when the yield curve is steepening (more optimistic about the future) and worse when it is inverting (more pessimistic about the future).
Campbell Harvey, one of the first academics to publish on the inverted yield curve, put it succinctly in the recent Wall Street Journal article: “It is naive to think that you can just forecast the complex U.S. economy with a single measure from the bond market.”
We have no view on whether the yield curve is a reliable recessionary indicator. But we do think that measuring the trend or changes in the yield curve level can give us some reliable directional signals about the relative returns of select asset classes and factors.