Reading through the Inversion Leafs: Correlation is not causation
Investors panicked about the momentary 2yr-10yr inversion, but this is far from a deeply persistent inversion. For example, the longest streak has lasted 120 days for the 3mo-10yr curve and 208 days for the 2yr-10yr curve, with a total of about 4 inversions prior to a recession. Some research find that a more accurate signal is when most of the curve is inverted, while others put emphasis on money markets, or rate cuts being priced at the front end of the curve. While the evidence is mixed, the short-lived nature of the recent 2yr-10yr inversion is encouraging on the economic front. Meanwhile, fed-funds futures pricing and the persistent inversion of the 3m-10yr curve signals that Fed easing is deeply expected, not that a recession is imminent.
Because the shape of the yield curve is more a symptom rather than a true driver of growth, other business cycle indicators must be examined. For example, the top 5 economic indicators that track the National Bureau of Economic Research (NBER)’s recession dating (link) are initial jobless claims, auto sales, industrial production, the Philly Fed index, and hours worked. Of these, hours worked have recently contracted and further declines could give way to job cuts (firm’s generally first act on the intensive margin and cut back hours before turning to layoffs). Meanwhile, employment and business investment look better. Construction and temporary help service jobs remain in expansion, while core capex orders rebounded in July. Key drivers of current investment (intellectual property and information processing equipment investment) are also showing no signs of an earnings recession.
More importantly, the chief causes of recessions are asset-price bubbles, leverage, policy mistakes, and commodity price shocks. Corporate leverage is running at all-time highs, but the pace of expansion has slowed and credit markets remain calm. Second is Fed policy, which has failed to exceed dovish expectations at the last meeting in July. The flattening of the yield curve that followed the July rate cut can be interpreted as a bearish signal for the economy because of fear of a Fed policy mistake.
Asset-Performance after a Yield-Curve Inversion
Following five periods of inversion in the U.S., equities usually perform well in the subsequent 12-24 months, with a notable outperformance during insurance-cut cycles. The S&P 500 has gained on average 11% over the last 12 months, ranging from a decline of -4% (2000-01) to a gain of 27% (1988-89). Sectors outperforming in the year following the past two 2yr-10yr inversions were financials, utilities and energy. More broadly, cyclicals and defensives lead, while value has outperformed growth in such episodes.