"More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly." — Woody Allen

I think the quote above captures much of the commentary around last Friday’s yield curve inversion. For those who are not up to speed, the Fed made a surprisingly dovish statement after its latest meeting, where it essentially put rate increases on hold for the year and noted it would be stopping the drawdown of the balance sheet this year. As a result, markets dropped their expectations for rates—and rates subsequently declined. This decline left the interest rate on 3-month debt above that on 10-year debt, which is the definition of a yield curve inversion.

If you think about it, the fact that you can borrow cheaper for 10 years than for 3 months is a signal that something is broken. It is simply riskier to lend for longer, so the imbalance shows that something is wrong. As such, the yield curve inversion makes sense as a risk indicator.

Empirically, it also works. Historically, an inversion of the yield curve has indeed been followed by a recession and a market downturn, not always in that order. Based on history, all of the doom and gloom makes sense. It may, however, be a bit premature.

A Look At Previous Inversions

The chart below provides a look at previous inversions. You can see that, typically, an inversion lasts for several months and then un-inverts—at which point we have a recession in a couple of months. Right now, we are at the start of that process, which usually lasts at least six months and often a year or more. In other words, yes, a recession is probably coming, but 2020 looks more likely than 2019.

Also worth noting is that the stock market tends to keep rising for some time even after the curve inverts. This pattern makes sense, as an inverted curve means growth is slowing—but not negative. Persistent growth, even at a slower rate, continues to drive up earnings.

No Immediate Risk (Yet)

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