Research demonstrates that over the past 50 years, every U.S. recession may have been predicted ahead of time by using one simple indicator–the spread between short and long-term government bonds. Usually, long-term bonds offer higher yields than short-term bonds due to the additional risk that an investor assumes when buying bonds with longer maturities. However, every once in a while the dynamic flips, where short-term government bonds offer higher yields than long-term government bonds. This event, known as a “yield curve inversion,” has predated every U.S. recession since the 1960s.
Last week, on March 22nd, the yield curve inverted once again, the first time doing so since 2007. Given the perfect track record for predicting recessions over the past 50 years, this event is going to get a lot of publicity and we wanted to bring you additional context. Last fall, Dimensional produced this short white paper, The Flat-Out Truth, highlighting that while this recession indicator has certainly worked in the U.S., it’s been less effective in other countries. Also, while predicting a recession seems like a useful tool, the reality is that selling out of stocks due to a yield curve inversion has not been likely to produce higher returns, since an inversion can occur many months, if not years ahead of a market downturn.
The reality is that a yield curve inversion can signal many things, but impending stock market doom is not one of them. There are many instances of very strong stock market performance after an inversion and investors are better served to simply note the rarity of this event, while sticking with their long-term investment strategy.