Why We Shouldn't Panic About The Yield Curve...

Amber Hestla's picture

Thursday, August 22, 2019 - 12:00am

by Amber Hestla

If you follow financial markets, you almost certainly heard the news that the yield curve inverted. That news sparked a steep selloff in the stock market. 

The Dow Jones Industrial Average fell 800 points. That was the fourth largest one-day decline in history. 

Now, let's look at the news rationally. 


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In percentage terms, that 800-point decline was the 342nd biggest one-day drop. With the index above 25,000, the Dow fell 3.05% on Wednesday. That's still bad, but it's not as bad as it sounds when we hear it's the fourth worst one-day loss in history. 

DJIA chart

The yield curve inversion also isn't as bad it sounds. 

The yield curve is a graph showing current interest rates for various periods. Normally, the graph slopes upward because longer-term bonds carry higher interest rates. For example, a 15-year mortgage has a lower interest rate than a 30-year mortgage because there is less risk over 15 years. 

In the chart below, the curve is inverted. Yields on five-year Treasuries are lower than the yield on one-month Treasuries. 

treasuries chart

Last Wednesday morning, the yield of the 10-year Treasury dropped below the yield on the two-year Treasury. This is the part of the curve that economists follow closely. That was the news that created a panic on Wall Street. 

By the end of the day, the 10-year yield was above the yield on the two-year. But no one seemed to notice. The focus of financial news coverage shifted to the inversion. 

There is a good reason for that. Some economists noted that the five inversions of the 10/2 curve preceded recessions. The average time between inversion and recession was 22 months. But in at least two cases, the recession was underway by the time the yield curve inverted. 

On The Other Hand...
Whenever I see economists rushing to explain to something, I think of Harry Truman, the 33rd president of the United States. Truman supposedly said, "Give me a one-handed economist. All my economists say, 'on the one hand... and then '...on the other hand.'" 

On the yield curve inversion, there was at least one economist who called it a signal of questionable value, noting "an inverted yield curve has predicted 10 of the last 7 recessions." In other words, the curve can be wrong. 

Over at Income Trader, we aren't economists. We are investors, so the question is what happens in the stock market after a 10/2 inversion. Well, on average, the S&P 500 Index is up about 12% one year later. In the past, the stock market peaked about 15-18 months after this inversion. 

As an investor, I can't be like Truman's economists. I realize they were just hedging their views, because that's the safest way to express a view. Investors also need to hedge their opinions, but I prefer to be clear about the hedge. That means I have a clear explanation of what I expect along with a clear definition of what will cause me to change my mind. 

So, let's step back and look at the chart above with weekly data. 

DJIA chart 2

Now, we see that the Dow is basically where it was in January 2018. But there hasn't been much of a move during that time. There was the decline in the fourth quarter of last year. From high to low, the Dow dropped 19.4%. 

While that doesn't meet the formal definition of a bear market, it does raise the possibility that it was enough of a decline to reset the bull market. If that's the case, this is a normal pullback in a young bull market. That view is consistent with the fact that the S&P 500 generally peaks more than a year after a yield curve inversion. 

I want to wrap up by sharing one more piece of data that argues for new highs. It's the latest results of the survey done by the American Association of Individual Investors, or AAII. This survey dates back to 1987. For an average week, 38% of investors are bullish, 30% are bearish and 32% are neutral. 

Last week, just 23% were bullish, almost 45% were bearish and 32% were neutral. 

AAII chart 
Source: AAII.com

Over more than 40 years, this survey has shown that the majority of investors are usually wrong. When there are few bulls, like there are now, markets tend to rally. 

Action To Take
That makes sense. If markets were easy, every investor would enjoy success. We should expect most investors to be wrong because it is difficult to hold minority views. My opinions are informed by history, and history says we should be bullish for now. My opinion will also change as the facts change. A break of the downtrend on the weekly chart would change my opinion. But until we have that break, we should be cautiously bullish. 

For my Income Trader readers and I, that means we'll stick with our strategy of making high-income trades that pay us upfront. (We're often in and out of a trade within a few weeks...) It's the same strategy that produced 49 winners out of 49 trades last year -- and has produced winners 90.5% of the time over the last six years.

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Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.