The question continues to be whether this yield curve inversion will bring a recession.
Presently, the driving fear is that the US monetary policy may not be enough of a stimulus to keep the US economy from slipping into recession amidst the declining benefits of corporate tax cuts and the trade war with China. Thus, the answer is likely, yes.
Ironically, that has always been true as recessions are a reality in our domestic and global economies. A byproduct of monetary policy, natural growth cycle, and business cycle contractions, recessions can be especially punishing.
The fact is that, at the time writing this commentary, the yield curve had inverted three times. On a daily closing basis, the yield curve has yet to remain inverted, but the fact is that the yield curve, on an intra-day basis has inverted.
Over the past 50 years, inverted yield curves have preceded recessions – likely due to astute attention to central bank activity with policy, combined with other observations in business cycles. When we examine the timing of a recession following an inverted yield curve, we notice that it is a leading indicator. It can precede a recession by as much as 3 years. In the past three recessions, the amount of time from initial inversion to recession has varied but has not been less than 18 months.
The biggest challenge is that often the yield curve normalizes before a recession starts due to monetary policy easing. Nearly every time this happens, we begin to hear about how “it is different this time because ____.” The truth is: it is always different – though strangely similar.
In addition to the inversion, we have seen some further evidence of continued economic slowdown, however nothing significant enough to lead us to believe that a recession is imminent. Volatility often rises when major leading indicators are behaving in a negative manner, but recessions occur based on a combination of factors. Globally, the economy is much weaker than domestically, and risks are everywhere. Though things might get bumpy, it doesn’t mean stock markets couldn’t make gains.
Ned Davis put together a table that shows the stock market returns 3, 6 and 12 months after an inverted yield curve is first observed. It is remarkable that the median returns are positive! As I mentioned, each time is different, but there are always some similarities.
Ignoring these facts or reacting too dramatically can both be dangerous. The best course of action is to take this leading indicator and continue to look for the next clue. We have to keep examining the facts and data and looking to connect all the dots to reveal the true picture of where we are today versus where we think we will go tomorrow.
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