Inverted yield curve has not been useful for predicting bear markets in a timely fashion. Data here

Discussion in 'Fixed Income' started by Market_Observer, Apr 3, 2022.

  1. This week (01Apr2022), the yield curve has inverted in U.S Treasury bond markets. This is big news in financial media. Why is this a significant event? According to experts, the inverted yield curve is one of the best predictors of impending economic recession.

    As an investor, the question that interests me "Is the inverted yield curve a good predictor for an impending bear market in a timely fashion?" The keyword here is timely. Being early in financial markets is as good as being wrong even if the prediction turns out to be right eventually. It is useless in making predictions about bear markets, selling out early, only to see the market rise another 30% before the bear market finally sets in.

    Based on the number of news articles about the inverted yield curve, it seems market participants are getting spooked. It is a good habit to do an independent study on my own to avoid getting spooked and sell prematurely. Besides, I enjoy studying the financial markets anyway.

    I downloaded 69 years of monthly Treasury bond yield data all the way back to April 1953 from FRED (Federal Reserve Economic Data). This data source is as credible as it can get. I downloaded the corresponding 69 years of monthly S&P500 price quotes from Yahoo Finance. The prices have been adjusted for splits and dividends.

    S&P500 3-month to 12-month performance after the first occurrence of an inverted yield

    The table above shows S&P500's 3-month to 12-month gain after the first occurrence of an inverted yield. There were only 12 such occurrences in the past 69 years. Notice that the sample size is not large enough in the first place to draw reliable conclusions. This is a flaw when conducting data analysis on rare events.

    From 1955 to 1970, investors who sold after an inverted yield curve occurred will look smart most of the time.

    Unfortunately, from 1980 to 2020, investors who sold after an inverted yield curve occurred will look stupid most of the time. Investors who used the inverted yield curve as a selling indicator did not do well over the past 40 years.

    I tried to verify from the data whether the inverted yield curve is a timely predictor of the end of a bull market and the start of a bear market (best time to sell). I use the 13-month peak to mark this best time to sell.

    Definitions used for constructing the table
    Months classified as inverted yield months
    - 1yr yield < 10yr yield or 2 yr yield < 10yr yield or 3 yr yield < 10yr yield
    Months classified as the first occurrence of an inverted yield
    - Inverted yield happened in the current month but it did not happen in the prior 6 months
    Months classified as 13-month peak
    - Current month stock index price is higher than all prior 6 months and higher than all future 6 months. This is the start of a major bear market and the best time to sell.

    A good question to ask "How often does an S&P500 13-month peak happen at around the same time as an inverted yield curve?

    In other words, "How often was the S&P500 preceded and/or followed closely in time by the first occurrence of an inverted yield curve?"
    Here is the answer I got from the data.


    There were 28 13-month peaks in S&P500 from Apr 1953 to Feb2022. Out of these 28 occurrences, 7 of them were accurately predicted by the inverted yield curve in a timely fashion. All 7 happened between 1955 and 1980. None of the 7 accurate predictions happened in the past 40 years.

    To qualify as an accurate prediction, the first occurrence of an inverted yield curve is to happen within 3 months before or after the S&P 13-month peak (see the numbers highlighted in blue).

    I will not dispute the claim made by experts that an inverted yield curve has been a good predictor of an impending economic recession. I do not have the formal qualifications to argue with the experts. However, as a bear market predictor, my independent study shows that the inverted yield curve has not been a good predictor in the past 4o years.

    The inverted yield curve has not been useful for predicting bear markets in a timely fashion in the past 40 years. As an investor/trader, I am not going to get too worried about inverted yield curves today. It is more noise than signal.
  2. SunTrader


    A question (that I can't be bothered to do the research on myself lol) I have is how do interest-sensitive stocks do under a inverted yield curve scenario or is it just the looming rising rates overall?

    Like tech stocks in particular, because $SPX vs $NDX currently is -5.23% vs -10.30%.
  3. NoahA


    Sorry if I didn't look too closely at your data, so I'm not sure if this point is already accounted for, but from what I hear about an inverted yield curve, the recession can happen anywhere as far as 18 months out. Did your analysis take into account this lagging nature?
    piezoe likes this.
  4. In my analysis, I don't care about recession. I care about about whether the stock market is going into a bear market. The economy can go into recession but as long as the stock market continues to go up or at least doesn't go down too much, it doesn't bother me as an investor.

    Furthermore, an event that happens as far as 18 months out is useless to investors. The timing is off by too much.
    murray t turtle and NoahA like this.
  5. The problem with using interest rates to "conclude" about the markets... is that when interest first start to rise, the market is able to "absorb that negative" and continue higher. With each successive rise in rates, the market evaluates whether it can be absorbed without derailing the bull. Eventually... if rates rise enough... the market will succumb to the negative influence of higher rates. The problem is "eventually"... just when is that... how many rate hikes does it take?

    IOW... Just because rates have started to rise doesn't mean you should exit the party immediately... but you should start thinking about "dancing closer to the door".
    Last edited: Apr 3, 2022
    Market_Observer likes this.
  6. NoahA


  7. piezoe


    Suggestion. If your looking for a recession, look for peak corporate earnings usually following the inverted yield. Very difficult to have a recession without an earnings peak.
    I would say the earnings peak is more important than inverted yield. The inverted yield is a harbinger that doesn't always pan out.
  8. I'm not looking for a recession. My focus is on equity bear markets, not recession. Equity bear markets and economic recession are two separate matters. Sometimes they go hand-in-hand, sometimes they don't.
    murray t turtle likes this.
  9. SunTrader


    Think I heard it mentioned on Bloomberg recently that earnings growth peaked sometime last year.
  10. piezoe


    That may have been jumping the gun. (Though I thought there were signs of a peak trying to be made after the 2021 data was in, I am not acting on that because hard to reach peak nominal earnings, which is what's usually reported, during periods of rapidly increasing inflation. (Real earnings might tell a different story.) We have a war on and high energy prices on top of generally high inflation. We might see consumers cutting back on buying which is yet another variable. Peak earnings have proven to be one of the more reliable early indicators of a waning economy. I would say it is a necessary but not sufficient condition.

    I think the yield curve has been popular as an indicator because it typically gives very early, months to a year or more, warning of trouble ahead. But it is sensitive to Fed action and the Fed can act atypically such as holding rates low for an extraordinarily long time before hiking. Speaking of hiking, that might cause some people to give the Fed the finger and tell them to take a hike. Some of you have pointed out that the yield curve is rather unreliable, and I agree. What I look for is a confluence of several macro indicators.

    The administrations policies are economic goose-ers. The democrats love demand side stimulus, the Republicans love themselves. How successful the administration is in putting their policies into effect will depend on Congress. Right now it is the Senate's filibuster that is applying the brakes and the Breakmen are Manchin and Sinema. Interesting to see what happens in November.


    N.B. we have to remember that 2020 was "special". And usually there will be a rebound after special events such as a pandemic which federal government ignored and pretended didn't exist for a quarter, then responded to ineptly for the remainder of the year while trying to sweep its existence under the rug and directing the CDC to alter its reports. Thankfully the individual States took matters into their own hands and responded appropriately with quarantines and school closures. The 2021 rebound in our case was spearheaded by the new administration which recognized there was such a thing as the Covid virus and it wasn't a "Hoax".
    Last edited: Apr 5, 2022
    #10     Apr 5, 2022