At its March meeting, the Federal Reserve raised the federal funds rate by 25 basis points. The central bank also indicated that this is likely the start of a tightening cycle, as policymakers attempt to dampen the elevated levels of inflation seen since the start of the pandemic. Markets seem keenly focused on the yield curve in the United States, and whether its potential inversion would be an indicator that a recession is on the horizon. The most common relationship being monitored is the difference between 2-year and 10-year U.S. Treasury yields.
The chart below shows the yield spread between 10-year and 2-year treasuries going back to 1976. The red arrows denote times when the curve inverted, and the shaded areas show recessions as defined by the National Bureau of Economic Research.
Source: Putnam, Federal Reserve Bank of St. Louis
The curve has inverted seven times since 1976. A recession followed within two years of the inversion in six of the seven instances. The median time leading up to a recession was 16 months.
How did markets perform following an inversion? The table below shows the performance of the S&P 500 Index and Bloomberg U.S. Aggregate Bond Index in the 6 months and 12 months following inversion.
Market performance following inversion has been generally positive. The median return for the S&P 500 six months after inversion is 3.82% and 12.75% for the year after inversion. Similarly, bonds have done well with the Bloomberg U.S. Aggregate Bond Index gaining a median of 2.69% in the six months after and 6.17% in the year after inversion.
Source: Putnam, Bloomberg
The 10-year/2-year yield curve gets considerable media attention but the 10-year/3-month curve has also inverted prior to every recession. While the 10-year/2-year spread has compressed considerably in recent weeks, the 10-year/3-month spread has not inverted. It has steepened, as seen in the chart below, with the spread at 1.8% as of 3/28/2022.
Source: Putnam, Bloomberg
There are seven instances during the past 45 years where the 2-year/10-year yield curve inverted in the United States. In every instance but one, the U.S. economy went into recession within two years, and the median time to the onset of the recession was 16 months. The 10-year/3 month spread is not close to inverting today. However, inversion of the yield curve has hardly been an accurate predictor of future market performance, as the S&P 500 was positive in the 12 months following inversion in 5 out of the 7 instances. Similarly, the Bloomberg U.S. Aggregate Bond Index was also positive in 6 of those same 7 time periods.
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Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Investments in small and/or midsize companies increase the risk of greater price fluctuations. Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. You can lose money by investing in a mutual fund.
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