Yield curve inversion is bad for stocks - Not so fast

 

The inversion of the yield has proven to be one of the best indicators for a recession, but that begs the question of whether it is a good indicator about the stock market. It would seem on the surface that if an inversion forecasts a recession and a recession is an indicator of lower equity returns, there should be a link between the shape of the curve and equity returns. 

Unfortunately, the evidence is not very convincing. Of course, there are not that many inversions, so the sample is small. Additionally, it is not easy to say what is the appropriate time horizon. The yield curve may lead the recession forecast by more than a year and by the time the recession hits, it is time to buy equities.

Some research has looked at the pre- and post-inversion time period (the time after the market first goes into inversion) and finds that small and mid-cap stock underperform, large cap stocks, but the difference is not statistically significant. There are poorer returns once the curve inverts but again the difference may not be significant.

When looked at across countries, the Dimensional funds group found that in 10 of 14 cases equity returns were positive in home markets after 36 months. This no different than any 3 year period; 71%  versus the null of 77% for 5 different markets.

Putnam also did some work on this topic and looked over shorter horizons and found little evidence of a return decline. The exception is the 2000 inversion which may be clouding the judgment of investors. A detailed piece by NASDAQ and DORSEY WRIGHT finds a similar result.

MSCI shows no clear patter for equities when the curve inverts.

Bond markets do well after an inversion as reported by PGIM.