Topic #8 – S&P 500 tends to underperform following US yield curve uninversion
A yield curve and its inversion, a trusted signal of impending economic recession on the horizon, is a closely scrutinised indicator among market watchers. It has been over a year since the yield curve for US treasuries became inverted, where the short-term 2 Year treasury yield is higher than the long term 10-Year treasury yield, in addition to the fact this disparity was the largest in magnitude observed since 1981.
With the yield curve steepening lately where the 10-Year treasury yield is rising faster than the 2-Year treasury yield, the yield curve is approaching its closest to uninversion since the banking crisis took place in March. This report looks at the consequence on S&P 500’s performance when the yield curve uninverts and steepens thereafter.
Relationship between S&P 500 and US 10-Year and 2-Year Treasury Yield Spread
The US 10-2 Year treasury yield spread measures the difference between the difference between the US 10 Year and 2 Year treasury yields, in terms of basis points. A normal yield curve has a positive yield spread as investors would demand higher interest rates to compensate for the greater risks of holding treasuries with longer maturities. Conversely, a negative yield spread signifies an inverted yield curve where where the short-term yield is higher than that of the long term as investors are able to refinance short term bonds at increasing yields given the high interest rate environment.
Looking at the chart (Figure 1) which shows the weekly chart comparison of the S&P 500 and US 10-2 Year treasury yield spread since the 1980s, there is generally an inverse relationship between the 2 variables. This report will focus on the 4 instances in 1990, 2001, 2007 and 2019 when the yield spread steepened significantly post uninversion to analyse S&P 500’s performance 6 and 12 months, respectively, following the uninversion (Figure 2).
Excluding the data point in 2019 where the market rallied from an unprecedented US$2.2 trillion stimulus following the COVID-19 crisis, the S&P 500 has declined on average over 7% 6 months and over 9% a year after uninversion takes place, respectively. The data also shows significant drawdowns can occur in these 2 timeframes where the index declined over 11% 6 months post-uninversion in 2001, and market corrections over 14-17% a year after in 2001 and 2007.
Looking at the data since the 1980s, the uninversion of the yield curve does set off alarm bells among market watchers with the S&P 500 tending to post declines following this signal. In addition, in every instance following uninversion, the US economy went into recession within 2 years, with the median time at 16 months. A plausible reason why the yield curve can predict recessions is because market particpants anticipate the Fed will cut policy rates to provide monetary policy accommodation during a downturn. Long-term bonds which are more sensitive to interest rates than short term ones, will decline in price at a faster rate, resulting in long-term and short-term yield differential to increase and cause the yield curve to steepen.