EFG International : Yield curve inversion, recession risk and equity returns

In the period since World War II, the 10-2Y spread has inverted 11 times excluding the current episode. On average, it preceded a quarterly contraction of American GDP by six quarters and, if we consider only the period since 1988, the lead-time rises to eight quarters.

In the twelve months following these 11 instances of yield curve inversion, the S&P500 index of US equities rose two-thirds of the time. In the period since 1988, realised equity returns have exceeded the full sample average returns in the first three months after the curve inversions and on a 12-month horizon.

Furthermore, in the most period since 1988, the stock market has always outperformed US long-term government bonds in the first three months after the curve inversion and in three out of four occasions over a six-to-twelve-month horizon. However, on longer horizons equity market outperformance over government bonds was less pronounced than in the full sample.

To conclude, if what happened over the last 35 years is a reliable guide to the future, the recent inversion of the US 10-2Y yield spread does not necessarily signal an imminent recession. Furthermore, historical evidence shows that equity markets have often performed well in the 12 months after a yield curve inversion. Every situation is different and it is certainly worth taking note of recent yield curve behaviour as it signals a heightened degree of risk to the economy. However, the statistical evidence indicates that the recession signal would become much stronger should the 10Y-3M part of the curve invert.