Overview

For the yield curve indicator I look at the spread between the 10-year Treasury vs. the 3-month Treasury. When it is negative, the curve is inverted. But any analysis of the yield curve must go a lot deeper than whether part of it is simply inverted because that alone doesn’t tell you much. You need to try and figure out why it is inverted.

To me an inversion only counts when it occurs between very short-dated bonds (3-6 months max) and long-dated bonds (10 years) and the inversion occurs from the short end. I simply do not believe other inversions between various long bonds throw off a reliable indicator.

In 2019 the yield curve inverted when the 10 year Treasury sank beneath the 2 year. Did it precede a recession? No, in fact it preceded a major bull market. Why? Because the long end sank beneath the short end while the short end remained quite stable. This didn’t indicate concerns among lenders at the short end, it just meant that for whatever reason a lot of people were buying longer dated bonds. It certainly didn’t stop many market pundits from predicting a coming recession.

Put simply, the yield curve matters because it tells you about short-term borrowing costs relative to longer-term borrowing costs. Short-term lending is the life blood of the economy. When liquidity starts to evaporate, things slow down. It’s also a bit of a chicken-and-egg problem because liquidity evaporates because things are slowing down. The earnings picture beyond six months is simply impossible for anyone to predict and so is really not very useful for sizing up the market. The yield curve matters when it is indicating a money crunch. If the inversion is occurring for any other reason it’s not really telling you anything. Just think of the yield curve as a tool for monitoring credit conditions. If credit seems okay, it’s likely the stock market will hold up.

My philosophy on the yield curve

The yield curve is one of the most widely discussed and poorly understood market indicators. Anytime any part of the yield curve inverts you hear calls from all sides for a recession. Is any explanation offered for why the inversion automatically means recession? No- all you hear is that historically an inversion has preceded a recession on many occasions. That sort of analysis is like saying every time it rains my back hurts.

Moreover, most people don’t even agree on what constitutes an inversion. Is it the 2 year to 10 year? Or the 10 year to 30 year? Or the 3 month to 2 year? Shouldn’t it be fairly easy to explain if it’s such an important market prognostication tool?

Before I go too far down the rabbit hole, let me take a step back and explain what people mean when they talk about a yield curve inversion.

In a normal economic environment, all things being equal, the longer the term of a loan the higher the interest rate.

In the bond market bonds are issued for all types of maturities, from 30 days to 30 years. You can think of each maturity as its own market, lending money at different rates taking into account that specific time frame.

And so I say all this to clear up what I believe is a very poorly understood but oft-cited indicator. The yield curve is hugely important, but only when you consider the “why”. When the very short end of the yield curve, say 3-6 months suddenly spikes, it can mean there is a problem looming in the economy because the cost of borrowing is rising rapidly.

The reason that the short end is so key to the stock market and predicting a recession is the relationship between short-dated bonds and earnings. Borrowing is the life blood of our economy. When the cost of borrowing suddenly spikes it becomes very difficult for businesses to operate and it also means that lenders are suddenly concerned about their ability to pay it back. For example, right when the economy was shutting down for COVID, liquidity in short-dated bond markets completely evaporated. This caused yields to spike and quickly invert the longer-dated bonds. But a few days later when the Fed restored order to the markets by fully backing all bonds, the inversion quickly reversed. In this case there was no great mystery as to why the curve inverted and went back. But in past cycles it hasn’t been clear at all and so minding the curve was hugely important because the bond market sensed economic danger well before the stock market.