The word recession scares most investors since it inevitably means pain for stocks. Therefore, investors are always looking for a signal that the global and US economy is slowing down and a recession is coming.

Image: Dividend Power

One significant indicator is the yield curve, the plot of interest rates for US Treasury Bills and Bonds. The yield curve inverted this past week, causing worry for many investors.

Bear in mind though it does not really matter much for buy-and-hold investors. If your investing horizon is in years, a recession will be a relatively short period because stocks tend to rise in price over time.

According to the National Bureau of Economic Research (NBER), there have been 13 recessions since WWII. The average one lasted about 10.3 months, while the average growth period lasted 64.2 months. However, the average recession is generally getting shorter, and the most recent one, from February to April 2020, during the start of the COVID-19 pandemic, was a short two months.

So, what does an inverted yield curve mean, and is it really a recession signal?

The Yield Curve Inverted

An inverted yield curve has marked every recession. However, the reverse is not 100% true; an inverted yield curve does not always signal an impending recession. This fact makes the yield curve an excellent but imperfect indicator of recessions—more on this fact below.

The table shows the interest rates for US Treasuries. The 2-year bond interest rate is higher than the 10-year this past week, marking the first inversion since 2019. In addition, the 5-year bond interest rate is higher than the 10-year last week, marking the first inversion since 2006.

The chart below shows the inversion, also referred to as the negative spread.

Source: St. Louis Federal Reserve

What Does It Mean?

When the yield curve inverts, investors sell short-dated T-bills and bonds in favor of longer-dated ones. They do this because they are concerned about the near-term economy compared to the long-term economy. Investors are expecting interest rates and higher inflation in 2-years than in 10-years. In this case, it may indicate the expected effects of inflation, interest rate hikes by the US Federal Reserve, and the impact of the conflict in Ukraine.

However, an inverted yield curve is not always a recession signal.

The predictive power of inverted yield curves for recessions is not foolproof, but they are still excellent. In the past 40 years, the 2-year and 10-year yield curves have only been inverted 7% of the time. It has predicted six recessions since 1978 with only one false positive. Reportedly, there is more than a 66% chance of a recession in the next year and a 98% change in the next two years. However, the predictive power is reportedly better when the 3-month and 10-year US Treasury inverts.

However, an inverted yield curve does not predict precisely when a recession will occur. The time expired before the start of a recession has varied from six to 24 months.

What Happened to Stocks?

Stocks can perform poorly after an inverted yield curve, but not always. For instance, stocks returned 11% on average after an inverted yield curve. 

However, they do poorly during a recession, whether for long or short periods. For instance, during the COVID-19 pandemic recession, the S&P 500 Index was down about (-9.2%) from February to April 2020. In another example, according to Portfolio Insight*, stocks were down roughly (-35.5%) during the 18 months of the Great Recession.

Source: Portfolio Insight*

However, the critical point is that stocks recovered and eventually surpassed their pre-recession high. Sometimes, the recovery takes time.

Final Thoughts on Recession Signal

Overall, investors may be asking themselves what to do? 

The main point is that inversion of the yield curve is an excellent but not infallible signal for a future recession. The US economy is strong today with low unemployment, rising home prices, creating jobs, etc. Despite rising interest rates, they are still relatively low. Furthermore, the US Federal Reserve could quickly stop rate increases or start rebuying bonds flooding the economy with money again.

As buy-and-hold investors, most should take the time to review their portfolios and adjust as needed. If you picked your stocks wisely they might do well during the a recession. Recessions occur, stock prices come down, but they eventually recover based on history.