The Yield Curve

suggests that the US stock market is

Fairly Valued

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The US Treasury Yield Curve was recently inverted. This has historically been a very reliable indicator of upcoming recession as it reflects investor sentiment about future economic performance. Since WW2 every yield curve inversion has been followed by a recession in the following 6-18 months, and recessions are naturally correlated with decreased stock market returns. The below chart shows our model, tracking the spread between the 10-Year to 3-Month US Treasury Yield Curve. The inverted curve of 2019/2020 did in fact precede the subsequent April 2020 recession. We've now had several consecutive quarters of normalized rates, indicating market expectations of future growth.

Historical 10Y-3M Treasury Yield Spreads
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The yield curve refers to the chart of current pricing on US Treasury Debt instruments, by maturity. The US Treasury currently issues debt in maturities of 1, 2, 3, and 6 months -- and 1, 2, 3, 5, 7, 10, 20, and 30 years. These are bonds just like any other - meaning that if you bought $1,000 of the 10-year bonds with an interest rate of 2%, then you would pay $1,000 today, then receive $20 at the end of years 1-9, and receive $1,020 (representing $20 interest + your original $1,000) at the end of year 10. Current interest rates are shown on the US Treasury's website.

The interest rates that these bonds pay reflect two main factors: 1) the Federal Funds rate, and 2) expectations of future returns.

The Federal Funds Rate

The Federal Feds rate (aka the fed funds rate) is the target rate set by the US Federal Reserve and is the interest rate that banks use to lend/borrow from the Federal Reserve overnight. This is almost always the "interest rate" you hear about on the news when there are headlines about rates rising or falling, and this rate sets the foundation of almost all other economic interest rates. Since the fed funds rate is the rate at which you can effectively lend cash to the US Government overnight, this rate serves as the foundation of the yield curve - it is essentially a US Treasury bond with a 1-day maturity. When the Federal Reserve changes this rate, all other rates tend to change accordingly as well.

Figure 1
Federal Funds Effective Rate
Expectations of Future Returns

The Federal Reserve sets the overnight interest rate - but the interest rates on Treasury bonds from 1-month to 30-years are set by the market and fluctuate with investor demand. Let's assume, for example, that the Fed Funds rate is 2%. This indicates that investors can lend money to the US Government overnight and receive a 2% annualized rate of return. If that is true, then we would generally assume a 1-month Treasury bond rate to be a little higher than 2%. This is because investors value optionality. They like having access to their money in case something better comes along, so they require extra return if they're going to lock up their money for a full month.

To better illustrate this - assume that the 3-month Treasury bond rate is 2.5%. Again, this says that an investor can lend their money to the US Government for three months and receive 2.5% annualized interest in return. If you are the investor, what rate would you need to receive in order to extend this loan to the US Government from three months to ten years? Ten years is a long time, and many more attractive investment opportunities may come up. If you've committed your money to a US Treasury bond and won't get it back for ten years, you need to be getting paid enough for it to be comfortable that nothing better is going to come along in the meantime. Otherwise, why not just keep investing in the three month bond every three months? Accordingly, it is almost always the case that as the maturity period increases, the interest rate on Treasury bonds increases as well. This normal case is illustrated on the yield curve below, from Jan 2017.

Figure 2
Normal, upward sloping yield curve

Yield inversion is the term used when long term rates are lower than short term rates. This happens when investors are nervous about the future and expect short term rates to fall.

For example, assume that the economy is roaring, and the Fed Funds rate is 4%, 3-month rate is 4.5%, and the 10-year rate is 6%. This would be quite normal, as described above. Now assume that you are an investor who thinks that the economy is weakening, and likely to slow down in the near future. If this were to happen, you would predict that the Federal Reserve would need to lower interest rates in order to juice the economy a bit (i.e., basic monetary policy). If this were true, and you expected all rates to go down in the near future, you would invest more in long-term bonds (10, 20, 30-year), in order to 'lock in' those good rates. When many investors begin to do this, the rates of long term bonds fall, and may actually fall below the rate of short term bonds.

Inverted yield curves are very rare - occurring only once a decade or so, and almost always immediately before a recession.

Current Rates

Figure 3
Current, inverted yield curve

Note from the chart above how the front end of the curve is pretty flat. The curve was fully inverted in fall 2019 and is now correcting back to a more normal shape. The traditional measure of whether or not the yield curve is said to be flat or inverted is by examining the relationship between the 3-month and 10-year rates. Let's do that below, and also layer on top bars that indicate US economic recessions, as well as a new line showing the average spread over the last ~60 years.

Figure 4
Historical 10Y-3M Treasury Yield Spreads

... and now the same chart, just zoomed in to look at 2000 through the present.

Figure 5
Historical 10Y-3M Treasury Yield Spreads

Figures 4 and 5 show the 10-year treasury interest rate minus the 3-month rate, back to 1960 (and then again from only 2000 to provide more detail in the narrow range). In a normal rate environment the 10-year rate is much higher than the 3-month rate, so this spread will be a positive number. As the spread moves closer to zero, and as it turns negative, it reflects the 10-year rate falling below the three month rate, indicating that investors expect future economic slowdown in the near term. As you can see by the shaded recession areas, investors have almost always been correct in this prediction. For the last 50 years, every yield curve inversion has been soon followed by economic recession.

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Our Model

We now have all the data we need - but in order to get a better sense of the historical trend, we present it in a slightly different way. Figure 4 above showed the historical 10-Year to 3-Month yield spread, including the average spread over that time of 1.53%. Below we reproduce this same chart, but with the data centered around that average 1.53% value. In order to get a sense of the volatility of the data, we show bands of plus and minus 1 standard deviation from the average. This can be seen below in Figure 6.

Figure 6
Historical 10Y-3M Treasury Yield Spreads

Statistically, about two-thirds of the time the yield spread should be within 1 standard deviation from the average. Broadly speaking, when the spread is below the average it indicates a selling opportunity, as flat/negative spreads are correlated with economic recessions and market downturns. Conversely, highly positive yield spreads tend to be buying opportunities, as they typically occur right after a rate-reduction policy response to a market downturn (i.e., when the market tanks the fed cuts short term rates to 0, and so yield spreads are high).

Because other market valuation models that we track tend to illustrate overvalued markets as positive on the y-axis, the final thing we'll do is flip the y-axis on this chart. Shown below, we now have the same 10Y-3M yield spread data, only with a "what goes up must come down" orientation.

Figure 7
Historical 10Y-3M Treasury Yield Spreads

At the far right of the chart you can see our current position, having recently exited negative spread (inverted yield curve) territory, predicting the 2020/21 economic recession and market drop. Since then, the yield curve has again normalized, and rates indicate market expectations for future growth.

The New York Federal Reserve uses the yield curve to calculate the probability that the US economy will be in a recession in 12 months. (Note: the calc is whether or not there we will be in a recession 12 months from the day of the calculation, not anytime in the subsequent 12 months). Currently, the NY Fed assigns a 8% probability that the US will be in a recession in Fall 2022.

Figure 8
Historical 10Y-3M Treasury Yield Spreads

S&P500 Performance

So far we've seen that yield curve inversions are highly correlated with subsequent economic recessions - but what can that tell us about stock market valuation? Does a yield curve inversion also precede market crashes? Do periods of 'normal' sloping yield curves correlate with positive market returns?

The below two charts illustrate the 10Year - 3Month yield curve spread mapped over S&P500 returns. The lines themselves are just the price of the S&P500, with the color highlighted during periods of yield curve inversion. Clearly, you can see strong correlation where periods of inversion tend to precede stock market devaluations. The top chart (Figure 9) is the normal S&P500 you're used to seeing - the bottom chart (Figure 10) is the same data but with a logarithmic scale on the y-axis so that early periods are less vertically condensed.

Figure 9
S&P500 with 10Y/3M Yield Curve Inversions Highlighted
Figure 10
S&P500 with 10Y/3M Yield Curve Inversions Highlighted - Log Scale

Data Sources

The below table cites all data and sources used in constructing the charts, or otherwise referred to, on this page.

Item Source
Federal Funds Rate Board of Governors of the Federal Reserve System (US), Effective Federal Funds Rate [FEDFUNDS], retrieved from FRED, Federal Reserve Bank of St. Louis;
US Treasury Yields U.S. Department of the Treasury - Daily Treasury Yield Curve Rates
Recession Data The National Bureau of Economic Research (NBER)
NY Fed Federal Reserve Bank of New York - The Yield Curve as a Leading Indicator, Yield Curve prediction model of future recession.
SP500 Data Yahoo! Finance S&P500 Monthly Close Values

Other Resources

Below are additional resources on yield inversion.