The yield curve inverted for real on March 22. It was a far more serious episode than the mild inversion we wrote about in December 2018.

We told you not to worry about that last inversion. The latest inversion is more serious, and a warning sign for the economy — and yet it could also be bullish, not bearish, for growth stocks.

We explained the basic concept of a yield curve inversion in December, but as a quick refresher, a “normal” yield curve is one in which long-term rates are above short-term rates, which looks like this:

normal yield curve

And an inverted yield curve is one in which short-term rates are above long-term rates, like this:

inverted yield curve

The first thing to note is that not all yield curve inversions are the same. The inversion we saw in December was more in the middle of the curve, between the 3-year and the 5-year treasury. What matters most is when the long and short end of the curve invert, like the outer edges of a seesaw.

The gold standard for yield curve inversions is the 10-year yield going below the 3-month t-bill yield, which didn’t occur in December 2018, but did occur on March 22 — for the first time since 2007.

By this 10-year versus 3-month standard, an inverted yield curve is considered a reliable recession indicator. According to the Cleveland Federal Reserve, the past seven recessions were all correctly signaled by an inversion of that type, with a lead time of 12 months or more.

Meanwhile there were only two “false positives” with this signal — where inversion or severe flattening was not followed by recession — in 1966 and 1998. (It should also be noted those were strange years.)

A yield curve inversion signals recession because long-term interest rates are a mood forecast for the economy’s future state. If long-term rates fall below normal levels, it means investors are anticipating gloom.

But what about the bullish equities part? It seems almost bizarre that an inverted yield curve — which is indeed a reliable recession indicator — would be a bullish sign for growth stocks. This odd reality makes sense for three reasons:

  • At the time of inversion, the recession is usually still far off (a year or more).
  • The inversion typically occurs near the peak of a bullish cycle, but not the very end.
  • The inversion causes the Federal Reserve to say “whoa” and revert to easy money.

In markets, timing means a lot. If a recession signal means gloom is coming, but the gloom is still a year out or more, bullish investors and money managers may shrug and keep buying their favorite names because why not? It is natural human behavior to push the envelope — if you know the party will be over at midnight, stay until 11:55 p.m., that kind of thing.

Inverted yield curves also tend to happen in a bullish part of the cycle. They typically show up when things have been good for a while — the bulls have been winning, and animal spirits are strong.

Again, this is like the 11 o’clock hour for a party that ends at midnight — it’s close to over, but there is still time and room for more upside.

And if we look around, we can confirm that speculative fever still abounds in certain parts of the market. Take Lyft for example, the Silicon Valley ride-sharing company (and smaller competitor to Uber) that went public this week.

Lyft is burning money hand over fist. It is practically shoveling cash into a furnace — and yet investors couldn’t wait to buy it.

“Lyft will serve as one of the biggest tests ever of investors’ appetite for money-losing companies,” The Wall Street Journal reported.

“Lyft has raised the price range for shares in its initial public offering,” added the Financial Times, “reflecting robust appetite for the first big U.S. technology IPO in two years.”

So, money managers are looking at the inverted yield curve and reasoning that, based on historical data, a recession is probably still a ways off. They are also looking at the oversubscribed IPO response to giant cash-burners like Lyft, and they see that animal spirits are alive and well.

To complete the puzzle, we have the Federal Reserve, which goes back to “easy money” when the yield curve inverts, to try to protect the economy and keep the expansion going longer.

You’ve heard of Newton’s Third Law: For every action, there is an equal and opposite reaction.

Newton’s Third Law does not apply to the stock market versus the Fed, because often times the reaction is far bigger than the initial action when those two forces meet. That looks something like this:

  • A piece of bad news or a negative economic indicator creates worry
  • The Federal Reserve reverts to easy money or stimulates excessively
  • The Fed actions have a more bullish impact than the worry was bearish

This strange dance is further aided by the fact that money managers everywhere have permanent incentive to see a rising market rather than a falling one (almost none of them are short). So, when they see a chance to dial up their bullishness via the Fed’s dovish reaction, they take it.

And this is why an inverted yield curve can credibly signal a recession on the horizon — which it does, with a window of 12 months or more — while still being medium-term bullish for growth stocks.

Marko Kolanovic, the global head of macro quantitative and derivatives research at JP Morgan, notes that this bullish phenomenon — in which pro-growth and pro-cyclical areas of the market outperformed after a 10-year versus 3-month inversion — occurred in 1978, 1989, 1998, and 2006.

So, is it time to be concerned about the economy? If you’re looking out to 2020, absolutely.

But in the here and now, don’t be surprised if investors wind up piling back into growth stocks (as the too-early bears scratch their heads).

Richard Smith
Richard Smith, Ph.D.
CEO & Founder, TradeSmith