A current debate is whether the yield curve is going to invert and what that ultimately means for equity markets. The yield curve is often considered the leading indicator of leading economic indicators, and it has been the predictor of seven of the past seven recessions. There have been several studies on which two maturities to use and in this case we are using the 10-year Treasury minus the 2-year Treasury.
The chart below from Dimensional Fund Advisors depicts the 10-year and 2-year Treasury spreads as well as the growth of wealth of $1,000 invested in the S&P 500 dating back to 1976.
Source: Dimensional Fund Advisors1
So is it Causation or Correlation?
Just because an inverted yield curve has preceded the past seven recessions, it doesn’t mean causation exists. When you think about why the yield curve inverts, it becomes a little clearer that it’s the underlying current that ultimately results in the economy’s stalling. For instance, when the Fed starts to raise rates it tends to do so later in the business cycle when inflation is picking up and the economy is overheating. By raising rates, growth starts to become restricted, and slowing growth trickles down into a multitude of different businesses. Slowing economic growth is much more of a cause than an inverted yield curve.
While the curve may invert, what’s going on behind the scenes of the yield curve is where one should focus to get a better read on where we are heading. As evidenced by the chart above, most of this tends to be more noise over the long haul. That’s why we advise to have a long-term plan and reside within your appropriate risk tolerance to help mitigate any short-term noise.
The S&P 500 is not an investable index and actual result may differ from historic performance.
1Crill,Wes. “What Does a Yield Curve Inversion Mean for Investors?" Dimensional Fund Advisors. August 30th, 2018
