Inverted

Inverted

Charlie: Excuse me, Lieutenant. Is there something wrong?
Maverick: Yes ma’am, the data on the MiG is inaccurate.
Charlie: How’s that, Lieutenant?
Maverick: Well, I just happened to see a MiG 28 do a…
Goose: We!
Maverick: Uh, sorry Goose. WE happened to see a MiG 28 do a 4G negative dive.
Charlie: Where did you see this?
Maverick: Uh, that’s classified.
Charlie: It’s what?
Maverick: It’s classified. I could tell you, but then I’d have to kill you.
Charlie: So, lieutenant, where exactly were you?
Maverick: Well, WE…
Goose: Thank you.
Maverick: Started up on his six, when he pulled in through the clouds, and then I moved in above him.
Charlie: Well, if you were directly above him, how could you see him?
Maverick: Because I was inverted.

Most readers should recognize this sequence from the movie Top Gun. The scene is one of my favorites. Investors are probably growing weary of the word inverted. Market pundits are fixated on the current slope of the yield curve as it reached its flattest level in a decade—flirting with inversion. A historical review of the yield curve reveals that its current (and potential) shape are not that uncommon.

The common metric for judging the slope of the yield curve is the difference between the yield of the 10-year and the 2-year Treasury Constant Maturity (the 2-10 spread). As the Federal Open Market Committee (FOMC) has recently accelerated its tightening campaign, the curve has flattened. Since 2016, the FOMC has increased the federal funds rate six times—from 0.50-0.75 percent to 2.00-2.25 percent. Over this time period, the 2-10 spread has decreased from 125 basis points to its current level of about 25 basis points (100 basis points = 1 percent).

Why all the fuss? Yield curve inversions have a reputation as predictors of recessions.

Indeed, an inverted curve has preceded the last seven recessions going back to the late 1960’s. However, the timing of the onset has not been consistent and false warnings have happened. BMO Global Asset Management examined this conundrum in their second quarter 2018 Fixed Income Insights. The entire article can be found here; however, below is a key chart from the musing.

I glean a few things from the above table. First, the predictive power is not 100 percent—which is already known. Second, you can’t time this metric. The length of inversion, or time in which it precedes a recession varies. For example, from the beginning of inversion; the period to a recession (if at all) ranges from three months to two years.

In addition to the aforementioned, the yield curve can remain flat for an extended period of time. The chart below depicts the number of days in which the yield curve was in a flattened state before reaching inversion. A flattened state is defined as the point at which the 2-10 spread is below 50 bps (my definition). Inversion is reached when the line crosses the zero axes. In 2018, the 2-10 spread first broke 50 bps on March 28. The spread has not constantly remained below this level; however, I am using that date as the starting point.

Ironically, the period quickest to inversion (152 days) preceded the longest inverted curve at 525 days (December 2005 – June 2007). And the recession that followed was extremely painful. In the two other periods, the curve was in a flattened state for over 300 days before the spread went negative.

What does all this mean? Don’t ignore this metric, but don’t rush to judgment. Investors are better served by reviewing their portfolio’s asset allocation to ensure it aligns with their risk and return objectives. Success should be measured by the progress towards your financial goals, not short-term fluctuations of the markets.

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