Signs of cooling inflation and a slowing but still growing economy have helped drive Treasury yields lower across the curve (today’s move notwithstanding). However, the recent shift on the yield curve has not been parallel across maturities, as the more monetary-policy-sensitive 2-year Treasury yield fell more than 10-year yields.
The bull steepener — when short-term rates fall more than longer-term rates — has left the closely watched 10-year minus 2-year Treasury curve spread only about 0.16% away from ending its record-long inversion of 529 trading days.
Source: LPL Research, Bloomberg 08/15/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.
While a dis-inversion of the curve preceded the last four recessions, context is key as Federal Reserve (Fed) rate cuts during those periods had more to do with spurring economic growth than policymaker confidence in receding inflation. The chart below provides some additional background on how the S&P 500 performed one year before and after curve spreads normalized during each of those recessionary periods (2024 is also included for additional context). Despite the negative headlines that often accompany a dis-inversion, only the normalization of the yield curve in 2007 produced a negative forward 12-month return for stocks.
S&P 500 Performance Before and After the Treasury Curve Normalizes
Source: LPL Research, Bloomberg 08/15/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.
There is often a lot of choppiness in rates when the 10-year minus 2-year curve spread approaches the breakeven point, and not every crossover above zero results in spreads remaining positive for a prolonged period. Given this backdrop, we also backtested a simple trading model that went long the S&P 500 (a hypothetical buy) every time curve spreads crossed above zero. Of the 23 signals generated on a weekly basis since 1980, the S&P 500 generated an average 52-week price return of 9.8%, with 65% of occurrences producing positive results.
S&P 500 Performance Following All Yield Curve Disinversions
Source: LPL Research, Bloomberg 08/15/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.
Summary
The shape of the yield curve receives a lot of attention in the financial media, especially when it crosses above and below zero. However, its use as a recession indicator needs some additional context. First, both an inversion and dis-inversion often precede a recession, but the timing of when the actual recession occurs can vary significantly after each signal. Second, the ominous headlines over the curve normalizing do not necessarily align with historical market performance, as the S&P 500 tends to trade higher after curve spreads cross back above zero.
Overall, LPL’s Strategic and Tactical Asset Allocation Committee (STAAC) maintains its tactical neutral stance on equities, while actively monitoring for signs of an inflection point during this pullback. The Committee maintains its modest overweight to fixed income, funded from cash, which can help buffer against equity market volatility should economic conditions worsen.
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