August 12, 2022: Inversion of the U.S. Yield Curve continues

Following the July 17, 2022, Market Minute titled: Global Yield Curves, we noted that seven countries around the world had inverted yield curves. Less than a month later, that number has climbed now to 17.

The closely watched 2 and 10-year bond yield spread of Chile, Czech Republic, Poland, Iceland, Canada, Sweden, Qatar, United States, Hong Kong, New Zealand, Norway, Turkey, Hungary, Pakistan, Brazil, Mexico, and Ukraine are all inverted.

The importance of this action is that an inverted yield curve (particularly in the U.S.) is a precursor to a recession (Chart 1).

In Chart 1, the current spread is larger than in 2007 and at a similar level to 2000 and 1989.

However, on the plus side, of the past 7 recessions, only two marked a deep recession (2000 and 2006). The other recessions were shorter and less severe. The deep yield curve inversion from 1980 to 1982 was at the end of the last bear market. By the end of 1982, a new bull market was beginning.

What does it mean?: A yield curve inversion does not always signal a deep recession. Since the late 1970's, one inversion (1980 to 1982) was at the end of the bear market, another was during a sharp and brief market decline in 1989. The 2000 and 2006 inversions foretold two deep bear market corrections. And in late 2019, a very minor inversion developed and alerted investors to a likely market retracement. In early 2020, that pullback occurred.

What should investors do? The current U.S. inverted yield curve (Chart 2) has continued for almost a month. This prolonged action suggests that recession and a market correction are very likely in the next 6 to 9 months. What is not known is the depth and duration of this expected recession and the market's correction.

Given that bull market tops are usually associated with excessive greed and optimism (all in mentality) and that there is an enormous amount of cash on the sidelines ($500 billion in mutual funds), the expectation is for a correction similar to the late 1980s.