Monday, April 23, 2018

How Do Stocks Typically React When the Yield Curve Inverts?

  • The 10 Year Treasury yield is currently pushing upward testing the 3% level, a mark that it has not breached on a month end close basis since July 2011.
  • Over the past year the Treasury yield curve 10 / 2 spread has contracted from 105 basis points to as low as 41 in the past week, raising market fear that it will turn negative in the coming year.
  •  An inverted yield curve is historically a sign of trouble ahead for stocks and the economy, but the actual impact on stocks is different in a rising rate inflationary environment versus a falling rate, deflationary market.

Short term interest rates have been rising much faster than long term interest rates over the last year.  Many investors use the tightening of the yield curve, and in particular 10 Year and the 2 Year Treasury spread as a recurrent signal that future economic activity is likely to slow down and the day of reckoning is near for stocks is near.   Over the past year the 10 / 2 spread has contracted from 105 to as low as 41 basis points.   The yield curve over the past several days has rebounded back to 50 basis points, with a sudden increase in the 10 Year toward the 3% level being the underlying driver to the spread widening.

The recent rebound in the spread aside, it is the contraction, and the prospect for a future inversion that currently has the attention of many investment strategist and analysts.  The problem I have with much of the current wisdom being rolled out for investor consumption is that it generally suffers from what happened most recently (deflation driven curve tightening), and it does not account for the fact that the Treasury is limiting new supply of the 10 year relative to shorter maturities, international demand for Treasuries (see TIC data here) is now falling in recent months rather than rising as it was in 2007 and 2008, and the Fed is still in capital control mode with plenty of excess reserves in the banking system tank (see here).  

In other words, if the yield curve inverts over the next year, it will most definitely have different implications for the financial system when compared to 2008 or even when compared to the year 2000.   And the primary reason I say this is that the yield curve currently is being driven by rising rate inflation building market pressures, not a falling rate deflation driven market. 

So with this in mind, I offer the following data for those who follow my blogs which will give some perspective on how to interpret a yield curve inversion relative to stocks in a rising rate inflation driven market (with low international fund flow influence), versus a falling rate deflation driven market (with high international fund flow influence).

In the graph below, which spans the last 66 years of market history, I have plotted the 10 / 2 Treasury interest rate spread over time and added the points in time the market corrected by 10% or more from a peak to trough basis on a month over month basis.    

Since the mid-1960s the major stock market “crashes” of 20% or more in the diagram began in Mar 1966, Nov 1968, Dec 1974, Nov 1980, Aug 1987, Aug 2000 and Oct 2007.  It remains to be seen if Jan 2018 becomes another similar stock “crash” peak in history, or just a correction along the way to higher stock prices.  Currently I place the probability as high that it will be a “crash” peak.

In the graph you will notice that there is one glaring characteristic difference in the yield curve inversion in a true inflation led rising rate market versus a deflating lower interest rate trend market.  And that difference is that the yield curve inversion happens after stocks have peaked, and it persists for a long period of time until the stock market finally cries “uncle.”   Once that point is reached, the Federal Reserve provides quantitative easing on the short end of the curve to reduce short term market interest rates relative to long term rates to encourage economic activity.  

A closer inspection of the inversion dynamics over a tighter time window will show the difference more vividly.

Last Two Major Stock Market Crashes Occurred after Yield Curve Inversion


In the case of the year 2000, Treasury interest rates were relatively high, borrowing needs were low thanks to a temporary fiscal budget surplus, and the stock market breakdown from the peak was beginning gradually.  The bottom in the market decline was not set until Sep 2002 and confirmed in February 2003.  At that point he 10/2 spread had expanded back above 2% after reaching a negative low point around the stock peak in the summer of 2000.  

The 2008 market crash was much more abrupt, but was preceded by a very long time span in which the 10/2 spread was either close to 0% or negative.  During the financial crisis in 2008 the Federal Reserve unloaded Treasuries from its own balance sheet tightening financial conditions even further, but interest rates fell anyway as the large volume of international “safe-haven” buying of Treasuries primarily from China drove Treasuries lower.  The interest rate signal that was most visible during the crisis was the rapid fall of the 2 Year Treasury rate. 

The 2008 crisis is a signature lower rate, asset deflation driven yield curve inversion where foreign capital flows into Treasuries seeking a safe haven happened simultaneous to a sharp sell-off in equities.  The data show that China was a major buying player in the Treasury market as the mayhem transpired. 

The Stock Market Crashes in the 1960s and 70s Started Before Yield Curve Inversion


If you dial back the financial market clock to the 1960s and 70s, you will see that the yield curve inversion relative to stock market peaks happened on a different timing cycle.

As you can readily see in the graph, 3 major stock market corrections began in the 1960s and early 1970s ahead of a significant inversion of the Treasury yield curve.  In fact, in the late 1960s, the yield curve was persistently in a range from 0 to 20 basis points for a considerable time (2 years plus) leading up to the stock market crash.  Once the market began to “crash”, it bottomed at the same time that the yield curve was at its most negative point.  In all three cases shown in the graph, the market bottom occurred as the yield curve was reversing from its most negative point.  This pattern in a rising rate market is vastly different from the yield curve inversion scenarios experienced post 1981 when interest rates began a 40 year decline and international dollar investment flows into US Treasuries substantially increased. 

How does the 1968 Scenario Stack up to 2018?


When reviewing historical yield curve data, it is important to understand that the situation faced by the Treasury at any point in time is unique to that period of time, and it is the situation that creates the behavior of the yield curve.  The biggest difference I have found between the 1960’s and 70’s versus today is the foreign trade deficit.  Up until the late 1960s, and really not starting in earnest until the 1980s, the US did not have a trade deficit; it ran low, but persistent trade surpluses dating all the way back into the 1800’s.  In addition, international trade was backed by gold which made every dollar in US trade convertible into gold at $35 per ounce under the Bretton Woods system instituted post WWII.   Since the US did not have a trade deficit and most trade dollars were converted back into gold, any deflation driven impact of wage differentials between the US and the rest of the world had to be absorbed within the US economy.   The primary driver for inflation became the “tax and spend” government fiscal policy which pushed higher and higher quantities of money into the US economy which was supply constrained relative to the government stimulated demand.
Although government borrowing during the 1960s was an order of magnitude lower than today, it was the relative rate of change in public debt that drove the interest rate market, as the federal government entered the market and began to crowd out other available investment options.  In 1968, there was minimal supply of re-cycled foreign flow of USD, which is the opposite of the market scenario experienced for the last 30 to 40 years.  Thus, the large relative increase in Treasury borrowing need in 1968 of $1B per month for 18 months, which was about 5% of the outstanding public debt at the time on an annual basis, caused a substantial move in Treasury rates on both the long and short end of the curve, but the spread between 2s and 10s remained persistently low, and did sink to a high minus territory until well after stocks began to decline from peak levels. 
Now, let’s fast forward to 2018.  The Treasury increased public debt outstanding at an annual rate of $500B in FYE2017 slightly lower but pretty much in-line with the past 4 years.  However, in FYE2018 the rate is going to be closer to $1.2T on an outstanding balance of $15T which puts the borrowing need at 8% of the current outstanding public debt balance on an annual basis.  In addition, this financing need is not a one-time hit like the path chosen in 2009 with the Obama administration economic plan.  This increased financing need is expected to expand even more in coming years. 

Voila, you have an accelerating government need for financing that is even worse than the 1968 time period on a relative basis, and far worse than the 2009 recovery economic plan.  In addition, you have an international flow of funds to fund the Treasury that is currently moving in the negative direction as the Trump economic plan works to tackle the “dirty float” issue that has persistently led to higher and higher trade deficits.  The one aspect of the scenario for rampant inflation that is missing is very large (10% plus) increases in year over year fiscal spending, which was present from 1966 through 1968.

Currently the Federal government is increasing the fiscal spending rate in the 4% range under the Trump plan.  However, since tax cuts are a form of spending if they are just a pass-through to consumer consumption, the net effect may actually be economically equivalent.  The same logic stands if the corporate tax cut is not spent on investment, but rather is just consumed by corporate buy-backs and in-directly spent on consumption by the selling party as may increasingly be the case as more baby boomers enter retirement.

Interpreting the Current Yield Curve Flattening


The burning investment issue that needs to be considered today is just how to interpret the tightening yield curve which is materializing in 2018 and what is the implication for the stock market going forward?

The current yield curve in many respects resembles the market structure that was evident in April of 2005 time period prior to reaching an inversion point in February of 2006.  

However, I would strongly advise not to read the current curve as being indicative of a re-run of the 2008 financial collapse, which happened 3 years later after the stock market went up from 1158 to over 1500 providing gains of over 30% in the time period, and expanding on a relative basis to almost 1X N-GDP.   Today, stocks are aggressively priced at 1.25X N-GDP, and the current volatility already signals trouble ahead for investors at the current valuation level.  So in this regard, the possibility that the stock market will continue to fall from this point forward, similar to the 1968 scenario is very high.  And, in fact, just as in the 1968 scenario, in all likelihood, interest rates will need to continue to rise in order to fund the Treasury as the safe-haven international bid from China for Treasuries will not materialize as it did in 2008. 

Under the present probable order of events, the next true stock market bottom will likely be reached when the yield curve reaches its greatest point of negative inversion, not when it has bounced back to plus 2% as it did in a declining rate deflationary market scenario.  This will be the point in time the Fed is forced to intervene by backing off its quantitative tightening path and monetize the Treasury debt by lowering rates on the front end of the curve by buying the debt off the market.  In addition, I expect the fiscal purse strings to be loosened even further in the next major stock market downturn because the timing will almost assuredly line up with a true economic recession.  By doing to, the long end of the curve will most likely rise rather than fall due to a shift in future inflation expectations. 

In other words, the aftermath of the next financial downturn in this likely unfolding scenario will be inflation driven, not deflation – the opposite of 2008 and the year 2000.  In fact, it would be the opposite of every stock market crash dating back to 1980 when interest rates peaked. 

If this scenario transpires as I strongly suspect that it will, you will truly know that the 40 year trend toward lower and lower interest rates is over.    Either way, deflation or inflation, the stock market is very likely going to be a relative loser over the next several years.

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Daniel Moore is the author of the book Theory of Financial Relativity.  All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell. 


  1. I am really enjoying following your articles. In terms of the article "What Will Make America Inflate Again", you speak about how the United States is a price taker, not maker. You also write about how the U.S. seems to have exported it's inflation overseas and how the Fed will seemingly not be able to prevent rising inflation with the short end of the yield curve. Have you done any research regarding emerging market countries and their relation to United States CPI? I enjoy seeing your correlations and graphs so that is why I ask. I know that just prior to the market crash emerging market growth seemed to be high and could have been a root cause to inflation. I know that this is your basic argument in your article, just wondering if you have any other correlation or graphs relating to emerging market countries growth, CPI in the United States, and how continued growth in emerging market countries is going to eventually inflate prices in the US. Thanks!

  2. Currently I am focused on the trade data and the relationship of emerging market growth in US trade (particularly China) and the effect on relative interest rates, inflation (lack of since China devalued its currency by 30% in 1994) and the steady decline in real economic growth over the last 30 years. I plan to publish more on this very relevant relative relationship in the future.

  3. Almost done with your book and think its awesome. On page 185 after only a couple of days. Going to read again to fully understand it. I was an Economics major at Arizona State and just started out in financial advising, passed the 7 and 66. Do you have any other books that you would recommend to similiar to this or that helped you in terms of managing your portfolio? Thank you and looking forward to your next publishings.

  4. Since you asked the question about books, I have to say that I am a loner when it comes to reading other peoples perspectives on investing and my own portfolio. I found there was a lack of books about market investing that get at the true underlying macro forces that are driving the changes in the market, and how to see and read the signals when they are in play. So when it comes to managing my own portfolio, I stick with my own understanding of the what the market is telling me - the perspective I share in the book. If I had to pick a major investor that I have a great deal of respect for their views on the market, it would have to be Jeremy Grantham. Here is a good article that may give you a sense of why I have this view:

    Although Jeremy G. does not have a book, there are additional good articles published from time to time about his views.