US yield curve: a good predictor of future equity returns?
Is the US economy inching towards the end of its record expansion? The US yield curve has a track record of correctly forecasting recessions which in turn have large implications for future stock market returns.
No one can accurately predict where markets will be in the future. At the end of July, Goldman Sachs raised their end of year S&P 500 forecast to 3100, which with the benefit of hindsight was unfortunate given that the market subsequently lost 5% over the following three days.
Whilst Goldman’s price target for the end of 2019 is still entirely possible, the odds are now far longer than on the day of Goldman’s update. Instead of targeting arbitrary price levels, longer-term investors may find it more constructive to look at a range of indicators to assess the future return prospects for stocks and other asset classes. These can be categorised into three main areas: the economic cycle, sentiment and valuations.
One of the most popular indicators used to judge where we may sit in the current market cycle is the shape of the US yield curve. An inverted yield curve, where short-dated bond yields rise above longer-dated yields, has correctly predicted every recession since the 1960s.
Where are we in the current cycle?
The length of a full business cycle has varied throughout history, with no rule on how long an economic expansion will last or how long a country remains in recession. The National Bureau of Economic Research calculates that the average business cycle lasts 4.7 years. Given that the previous recession was over ten years ago, should we be expecting economic growth to turn negative in the near future?
Towards the end of the business cycle, central banks will typically move to cool economic activity by raising interest rates. That is exactly what the US Federal Reserve (Fed) had been doing, increasing its policy rate by 0.25% for five consecutive quarters until its last hike in December 2018.
Figure 1: Recent path of the US Federal Funds target rate
The gradual tightening of monetary policy as the economic cycle matures shouldn’t alarm markets. But at the time of December’s rate hike, the US economy was only growing at a modest 2.3% year on year (YoY) and inflation was running at around 1.8% YoY. The Fed’s recent case for raising interest rates seemed to be less concentrated on preventing the economy from overheating, but more to do with bringing interest rates back up to more 'normal' levels.
What spooked markets on 3 October 2018 was Federal Reserve Chairman Jerome Powell’s comments that the central bank’s current policy rate was 'a long way from neutral'. The market interpreted this to mean that both the speed and size of rate hikes were to increase going forwards.
Some people view this a policy mistake by Powell. The withdrawal of ultra-accommodative monetary policy while economic growth remained mediocre, global political tensions were escalating and the trade war with China was heightening led to US equity markets shedding close to 20% over the quarter as the higher probability of future economic weakness was priced in.
How has the yield curve reacted?
In a 'normal' macroeconomic environment, investors can expect to earn a higher return by investing in treasury bonds with a longer maturity. Long-term bond yields represent the expected forward path for short-term interest rates plus a risk premium, which is mainly comprised of the higher interest rate risk that longer-dated bonds possess. This risk-reward trade-off typically means that the yield curve slopes upwards from left to right.
Figure 2: US treasury yield curve
The chart above shows how the yield curve has shifted from its standard upwards sloping shape in 2017 (dark blue) to today being inverted today, with the yield on 3-month bonds close to 0.50% higher than for the 10-year bond (light blue).
The gradual movement of the yield curve can be illustrated by taking the difference in yields between long and short-dated bonds, otherwise known as a bond yield spread. The two common spreads that are used are the 2-year/10-year and the 3-month/10-year. The 3-month/10-year is favoured by many since the shorter maturity is more indicative of current Fed policy.
Figure 3: Spread between 3-month and 10-year US Treasury bond yields
This chart shows 3-month/10-year spread going back to the 1980s. An inverted yield curve has been a very good predictor of an upcoming recession. The chart shows that going back to the 80s, each time the yield on 10-year Treasury bonds fell below yields on the 3-month Treasury bond, a recessionary period followed (highlighted by the shaded areas).
What’s more, the chart also shows how the speed at which the spread has narrowed quickened after Powell’s comments in October 2018, before turning negative in March 2019 for the first time in the cycle. July’s rate cut by the Fed has done little to change the markets view that longer-term interests will be lower than current short-term rates – effectively predicting that the Fed will now continue to cut its policy rate.
Larger bond yield inversion, the higher the chance of recession
What is more important than whether the spread is simply negative or not is how negative the yield spread is. The 3-month/10-year spread is currently just shy of -0.50%, which according to the New York Federal Reserve implies a 40% chance of recession within the next year.
Figure 4: Estimated 12-month recession probability
|Recession probability (percent)||Value of spread (percentage points)|
Source: NY Fed
The inversion looks to have recently made new lows recently, but the yield spread remains less negative than what was seen before the previous two US recessions. The same implied probability of recession reached 46% in November 2007 before the Great Financial Crisis and 53% around the time of the dot-com crash. Nevertheless, we are close to extreme levels judging by this indicator alone.
What an inverted yield curve means for the stock market
One should proceed with caution when using a market indicator in isolation to attempt to forecast future returns. As it is impossible to time the market to perfection, our range of IG Smart Portfolios are positioned to attempt to deliver risk-adjusted returns that beat our benchmarks over the longer term.
But how good a predictor is the yield curve in forecasting future stock market returns? To do this we took annualised five-year returns for the S&P 500 and plotted these against the spread between the 3-month and 10-year Treasury bonds.
The chart below shows a mixed relationship between the yield spread and future annual returns over a three-year period for the S&P 500. Note that these are price returns, dividends are excluded from the analysis. Going back to 1962, the correlation between the two is 0.33 which suggests a fairly weak positive relationship. However, we know that relationships can breakdown and recouple over time. Since the late 90s, the relationship appears to be a lot stronger with a far higher correlation of over 0.70, indicating a strong positive relationship.
Figure 5: Relationship between the yield spread and future S&P 500 returns
Since 1990, when the yield spread has fallen been below +0.50%, the average annualised three-year return on the S&P 500 was just 1.8%. When the yield spread turns negative, annual returns over the following three years averaged -2.1% per year.
Figure 6: Tight or negative yield spreads imply lower future equity returns
The chart above shows that in the past, as the yield spread tightens, the return you can expect on the S&P 500 declines. As aforementioned, the relationship prior to 1990 is weaker than in more recent history. What this suggests, though, is that with the yield spread currently at -0.5%, now may not be a good time to invest a large lump sum in US equities.
How do you position your portfolio with a possible recession on the way?
With bond and stock valuations looking expensive by historical standards, it can be tricky to know where to best invest your savings. As we have pointed out in the past, trying to time the market is near impossible. There is tonnes of research showing that humans are terrible at trying to beat the market buy timing when to enter and exit their investment. Behavioural traits such as loss aversion mean that individual investors often sell at market lows and buy back in later when market volatility has eased.
The most effective way of reducing portfolio risk, or volatility, is by investing across different asset classes. Equities are not perfectly correlated with bonds, commodities and other alternative assets such as property or private equity. Combining these different asset classes reduces your exposure to unsystematic, also known as diversifiable risk, and offers investors superior risk-adjusted returns.
In contrast, investing solely in equities from different areas of the world provides little diversification benefit. For instance, the correlation between UK and US stocks used to be 0.40% in 1980, but now they pretty much move in sync with a correlation of 0.85%. Of course, different areas of the world will grow at different rates from time to time, just like how US stocks have beaten UK stocks by a massive 9.2% per year over the last three years.
Our range of Smart Portfolios invest across a range of asset classes and are designed to provide investors with excellent risk-adjusted returns. You can see how our portfolios have performed against each of their benchmarks here.
Each of our Smart Portfolios are currently positioned cautiously in both fixed income and equities. The fixed income part of the portfolios therefore has limited exposure to longer duration bonds which reduces interest rate risk and also minimal exposure to the high-yield market.
And given that we have a significant amount invested in low risk bonds, we have scope to reallocate funds to increase the proportion invested in equities when the outlook for equity returns improves.
Why choose an IG Smart Portfolio?
Our annual management fee for complete investment management starts at just 0.65% and falls as your portfolio grows beyond certain thresholds. Including ETF costs and factoring in the market spread each time we buy and sell the ETFs that make up your portfolio, your total annual cost is no more than 0.86%. That’s just £86 per year if you have a portfolio worth £10,000.
We will never charge you when you want to adjust your portfolio. This means that when the amount of risk you want to take changes, there are no high costs of switching your investments.
If you decide you want to add in more funds, sell your portfolio or switch to a different portfolio, our technology lets you make the change throughout market hours, giving you far more flexibility than if you were invested in a traditional active fund, which typically only allow investors to buy and sell at one point in the day.