Investors might be freaking out about the inverted yield curve, but history indicates stocks could see significant upside from here.
The bond market might be flashing yellow, but investors shouldn’t worry too much just yet.
Last Friday, the spread between the 3-month Treasury bill and the 10-year note hit negative territory for the first time since 2007. The spread between the more broadly watched 2-year and 10-year notes is nearing inversion as well and has fallen to just 10 basis points compared to 60 basis points this time last year.
This was spurred on by the Federal Reserve downgrading their U.S. economic outlook for GDP to 2.1% in 2019 from 2.3% and signaling no rate hikes this year after having projected two rate hikes as recently as December, spooking bond traders and stoking concern that a recession is right around the corner.
But while an inverted yield curve has historically been a reliable recession indicator, it also tends to signal a period of strong returns for the stock market. That’s according to Marko Kolanovic, global head of macro quantitative and derivatives research at JPMorgan (NYSE: JPM).
“Historically, equity markets tended to produce some of the strongest returns in the months and quarters following an inversion,” Kolanovic wrote in a note from Tuesday. “Only after [around] 30 months does the S&P 500 return drop below average.”
Kolanovic looked at the path markets have taken after instances of a 10-year, 3-month inversion from 1978, 1989, 1998, and 2006. While he noted that this is a small sample, Kolanovic said he believes inversions show a strong similarity because they are a “result of a specific setup of monetary policy and the economic cycle, and hence are likely to produce a similar response by investors and central bankers.”
Kolanovic says the current inversion is similar to previous ones in that slowdowns in growth and Fed rate hikes have been the key drivers of the inversion.
According to a Credit Suisse analysis last year, stocks rise about 15% on average in the 18 months following inversions of the 2-year and 10-year yields, and the stock market doesn’t tend to turn sour until 24 months following an inversion of the yield curve.
“Yield curve inversion won’t signal doom,” said Jonathan Golub, chief U.S. equity strategist at Credit Suisse, in a note last year. “While an inversion has [preceded] each recession over the past 50 years, the lead time is extremely inconsistent, with a recession following anywhere from 14 – 34 months after the curve goes upside down.”
Pointing to the last recession, in 2008, Golub noted that it took 24 months for a recession to start after the 2-year and 10-year yield curve inverted on December 30, 2005. After that inversion, the stock market climbed 18.4% in 18 months and were up 17% 24 months later. In fact, stocks didn’t start to fall until 30 months afterward.
But Kolanovic warns that this time could be a bit different. Noting that the knowledge around inversions has become well known, Kolanovic says things could “play out quicker or slower this time.” However, don’t panic yet, “the time frame should be in quarters or years (rather than months),” Kolanovic said.