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What is a Yield Curve Inversion, and why is it important to stock investments?

What is a Yield Curve Inversion, and why is it important to stock investments?

September 13, 2022
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Before we jump into Yield Curves, first let's quickly recap what happened in the market last week. The stock market staged a robust rally during the holiday shortened week, after hitting a support level around 3900 on the S&P 500. There wasn’t any specific economic data to spark the rally but was more likely caused by the extreme oversold conditions from the past few weeks. Remember, the market only goes in one direction for so long before it reverses.

So what is a Yield Curve Inversion?

In normal economic conditions, bonds of longer duration, say 10 years, offer higher returns over bonds of shorter duration, say 2 years, which is called the bond yield curve and it changes based upon economic conditions. In unusual economic conditions, bonds of longer duration may offer lower returns than shorter term bonds and this is called a Yield Curve Inversion. In this cycle, it recently occurred on April 1st of 2022 and has drawn a lot of attention on Wall Street.

And why is it important to stocks?

It is important because traditionally it’s considered a negative indicator which influences stock investors to sell, or at least not to buy stocks. The stock market has indeed dropped this year, and this widely followed indicator had some influence on this drop. Many investors erroneously believe that an inverted yield curve leads to an economic recession. It’s true that every economic recession since 1956 was preceded by an inverted yield curve but, every inverted yield curve doesn’t lead to an economic recession. There have been many occasions in which stock returns have been very positive 12 months following an inversion with a median return of 8.5%. No one knows what the future holds but based upon historical probabilities (check out the charts below) there’s a higher chance of positive investment returns, even with an inverted yield curve.

            

Photograph by: Luke Stackpoole on Unsplash